The result of the US presidential election was probably surprising on two levels. Firstly, Donald Trump’s victory itself came as a surprise. And secondly, the analysts had made predictions for the event of Trump’s victory that did not match reality: after a very short moment of shock, the stock exchanges turned clearly into the positive. The bond markets, on the other hand, recorded a significant decline. In view of the announced higher spending on infrastructure and the planned tax cuts, the US budget deficit will rise drastically in the medium term. This also means higher inflation and would tend to trigger higher US Treasury yields. The correction of the US Treasury bonds also hit the stock exchanges in the emerging markets, which are negatively affected by the possible barriers to trade, such as higher import duties for certain goods, and the now stronger US dollar.
In the YOU INVEST funds we had already prior to the elections sold off US Treasury bonds either completely or, in case of the YOU INVEST solid fund, reduced them to about 5%. The assets were regrouped into inflation-protected euro bonds or into more aggressive emerging markets bond funds. With the exception of YOU INVEST solid, the weighting of classic government bonds from the Eurozone and the USA is therefore currently zero percent. We left the equity allocation of the funds unchanged. Within the equity portion, we slightly increased the weighting of US equities at the expense of equities from Canada, Australia, and Korea. US equities therefore account for slightly more than 40% of total equities.
On 10 March, the Council of the European Central Bank (ECB) loosened its monetary policy further, as had been expected. Here are the most important measures:
In view of the decline of the leading economic indicators and the excessively low inflation in the Eurozone, the bundle of measures introduced by the ECB is necessary. The economy is currently not running smoothly. Inflation remains low and is far from the ECB target of slightly below 2%. We are still waiting for effective tax policies and structural reforms.
What do the ECB measures mean for the investor? The yields of safe government bonds remain very low in the foreseeable future. The central bank expects unchanged rates for a sustainable period of time – or even lower ones, should the data deteriorate. Yield increases, if any, would then only be of a temporary nature.
All this exacerbates the desperate search for yield by investors. The incentives to shift to asset classes that promise a higher rate of return, but that also come with higher risk such as corporate bonds and equities, have increased. The incentives for banks to expand their lending volume have increased as well. This might lead the moderate economic upswing of the Eurozone to continue.
Forecasts are no reliable indicator for future developments.
Commodity prices have fallen drastically since the beginning of July. The commodity price index provided by Bloomberg has fallen by nearly 12%. In fact, many commodity prices are locked in a bear market. The index is currently almost 50% below the level of the beginning of 2011.
Over the same period the currencies of emerging countries have depreciated by about 35% vis-à-vis the US dollar, and equities have fallen by about 26%.
In line with these developments, real economic growth in the emerging countries has weakened significantly. The growth estimate for Q2 has been cut to only 2.5% q/q. Net of the Chinese economic growth, the remaining emerging economies (accounting for about two thirds) have even shrunk on aggregate. Industrial production has stagnated in the first half of the year, and both exports and export prices have fallen.
The most recent leading indicators also suggest that there is no end in sight for the downward trend. For example, the purchasing managers index for the manufacturing sector, as compiled by Markit, continued to fall in July. While at 49.1 it is currently only slightly below the threshold of 50, which indicates neither decline nor increase, the trend is headed downwards.
In the YOU INVEST portfolios we take this development into account and have reduced emerging markets corporate bonds to zero.
The current bailout programme with Greece is about to expire at the end of June. The new government in Greece has not accepted the terms of the programme right from the start. It hopes that the creditors will agree to a new programme with more favourable terms for Greece. It would be a rational move to reach an agreement both for the institutions and for Greece, with massive welfare losses and chaos in Greece as well as spill-over effects and the increase of the disintegration risk in the Eurozone looming in the absence of an agreement. It should be possible to reach a compromise between austerity and haircut if both parties are negotiating in good faith.
Nevertheless, a possible default and an ensuing exit from the Eurozone would not come as a surprise to anyone anymore at this point. The instruments of the central bank – unlimited provision of liquidity for a country in case of emergency and the bond purchase programme – restrict possible spill-over effects to equities and government bonds. Still, in the event of a default, risky assets are likely to incur temporary losses. In Greece, capital control would be implemented, and savings would be frozen. The Greek government would probably use (worthless) vouchers for its expenses at the beginning. In this scenario, new elections are realistic. But even in case of an agreement in the eleventh hour a sustainable solution is unlikely. After the crisis is before the crisis. Here one of the weaknesses of the Eurozone becomes apparent: the lack of the necessary institutions that would facilitate a common economic and financial policy. The countries of the Eurozone are not irrevocably tied to each other.
The strategy of the YOU INVEST portfolios adjusted towards the more conservative end at the beginning of June. The equity portion overall and the share of Eurozone government bonds were reduced, among others.
While the past weekend was characterised by upbeat events such as the wedding of the Swedish Prince Carl Philip and Sofia, the annual parade in honour of Queen Elizabeth II in London, and not the least the inspiring victory of the Austrian football team against Russia, the capital markets refused to get drawn in by this array of joyful occasions.
The big issues at the moment are the yield increase especially in the Eurozone, the timing of the first interest rate hike in the USA since 2006, and of course the never-ending Greek tragedy. In the Eurozone the ECB seems to have attained some of its goals that it had set itself by launching the government bond purchase programme. The euro has depreciated significantly, the inflation expectations have increased, and economic growth has shown first signs of recovery. For the investors, this trend reversal away from deflation and stagnation scenarios brought no positive trends whatsoever: the bonds corrected strongly, and the equity markets could not avoid this bout of correction either.
The situation in Greece is not helping. So far the worries of a contagion by other Eurozone countries have not materialised; that being said, in the past few days investors
seem to have become more sceptical again vis-à-vis the bonds of Portugal,
Spain, and Italy
The analysts that visited us earlier yesterday are looking at the situation from a different perspective. In their long-term interest rate outlook, they expect the yields of 10Y US Treasury bonds to be at 1.5% in 18 months from now (currently 2.4%), with the yields of German government bonds around that time at 0.5% (currently 0.83%). They also expect the Greek problem to be solved, but are – and have been for years – sceptical about the euro project due to the, in their opinion, overly mixed structure of the various economies.
Elevated volatility? Volatility on the markets has increased by about 50% (i.e. from 14 to 21%!) for European equities. As far as Eurozone government bonds are concerned, some banks are (again) considering the re-adjustment of their risk models. The gold price, one of the most important crisis indicators, still remains unaffected though.
The positioning of the YOU INVEST portfolios is currently a conservative one in the wake of the reduction of the equity share overall and of emerging markets equities in particular, as well as after the reduction in Eurozone government bonds last month. At the moment, the sentiment on the markets is not exactly harmonious.