Each month we share the conclusions from the monthly strategy investment committee which provides a summary of Ostrum’s views on the economy, strategy and markets.
The CIO letter
- Three uncertainties
For several months we have been quite cautious on the back of richly valued markets. This summer season leads us to adopt an even more cautious and wait-and-see attitude. Indeed, we are at a crossroads on three major topics.
The first topic is growth. An important part of the decline in US rates can be attributed to technical elements and liquidity flows. The persistence of the decline, steady since the beginning of April, however, raises concerns that it could also come from growing fears about economic growth, especially real rates are sending a worrying signal. Historically, fixed-income markets have often been prescient of the cyclical outlook … when they are free to move. The future of the economic trajectory raises questions, while already there are signs of overheating.
The second issue is . The figures in the United States remain much higher than expected and inflationary pressures are spreading in more and more sectors. Of course, part of the development is due to the base effects and is expected to wane during the coming quarters. The issue of persistence and the possibility of stabilizing well above 3%. Two-thirds of FOMC members now believe that the risks are tilted on the upside. This could have major implications for monetary policy.
Third, the virus. If the delta variant rapidly, it appears to be low-risk, health services are not congested, there is no need for a new confinement. But evolution remains highly unpredictable, and it is an indisputable subject of attention.
In this context, and with markets that are losing depth during the summer months, it is advisable not to take unreasonable risks before having a little more visibility.
Three themes for the markets
The level of vaccination progresses rapidly, but the Delta variant should be monitored. Its progression is rapid, even if its severity remains limited. Markets are very unprepared for bad news about the pandemic. Although more recently some of the risk has been taken into account.
The economic publications remain very strong and continue to surprise the economists’ consensus. However, there are signs of overheating and the sustainability of growth in the medium term is not assured. The interest rate market, in particular, sends a disturbing message.
Inflation is here, it is spreading in many sectors. There are also signs of persistence, although the basic effects will inevitably lead to a slowdown in the coming months. Central banks may not be patient indefinitely.
Key macroeconomic signposts
Strong activity in developed countries – Slowdown in Asia
- Surveys show continued rapid growth in activity in developed countries - Euro zone composite PMI index at its highest for 21 years.
- The catch-up effect continues with the continued lifting of restrictions in July.
- In addition, there are still expansionary fiscal policies and very accommodative monetary policies.
- This translates into a further acceleration of activity in the service sector - It moderates in the manufacturing sector to remain robust.
- Supply fails to adjust quickly to the sharp increase in demand, which results in pressure on production prices.
- Tensions on supply chains remain high for some products and sectors.
- In Asian countries, activity is affected by the tightening of restrictive measures to cope with the resurgence of the epidemic.
The main risk: the delta variant
- The main risk lies in the sharp rise in new contaminations linked to the delta variant.
The high vaccination rate in developed countries (nearly 50%) prevents a sharp increase in severe forms of Covid-19.
- This is less the case in emerging countries where less than 10% of the population is fully vaccinated as well as in other countries such as Australia.
- The tightening of restrictive measures in some countries weighs on their activity (in some Asian countries for the moment).
- This could increase tensions on supply chains and weigh on trade as well as activity and prices in developed countries.
- The outlook for business leaders is affected by the resurgence of the epidemic as revealed by Markit and IFO surveys in Germany.
Temporary acceleration of?
- has accelerated markedly with the gradual reopening of economies. Much of this is due to the base effect linked to energy prices. During the lockdown, the price of oil fell as demand collapsed, only to gradually increase as activity resumed. The price of a barrel of Brent is now around $ 75, compared to $ 43 a year ago, which translates into a strong contribution of energy prices to . This will remain high over the next few months.
- In addition, there are more recent temporary factors linked to the gradual lifting of the restrictive measures. This particularly affects the sectors that have been most affected by it, such as accommodation and food services. Shortages of certain raw materials and components also affect the production of certain goods. This is specifically the case with cars suffering from a lack of semiconductors.
- These tensions are expected to gradually dissipate with the rebalancing between supply and demand.
- In the United States, the rate stood at 5.4% in June, the highest since August 2008. The underlying index (which excludes food and energy) reached its highest since 1991 at 4.5%. The price of used cars rose sharply again following difficulties in the production of new cars, contributing 1.1 percentage points to headline in June.
- In the Eurozone, stood at 2.2% in July and moderated to 0.7% for the underlying index.
- Joe Biden's massive stimulus package for households most affected by the crisis and the inclusion of house prices largely explains the higher in the United States compared to the Eurozone.
The need for a still active fiscal policy
Progress on the infrastructure agreement
The bipartisan infrastructure deal reached between Joe Biden and a group of Republican and Democratic senators in late June is well under way. On July 28, it took a first step in the Senate in a preliminary vote supported by Democrats and some Republicans. Totaling $ 1,200 billion over 8 years, it includes $ 550 billion in new spending. The Democrats are preparing in parallel a reconciliation procedure intended to adopt the rest of the measures announced by Joe Biden without the support of the Republicans.
European recovery plan : new step
The European Commission has so far approved 14 recovery and resilience plans. While countries have requested all available grants, only Italy, Greece and Romania have so far requested the full envelope of available loans. The European Union has been carrying out the first issues since mid-June as part of Next GenerationEU. It raised 45 billion euros in 4 weeks. A first payment was made at the end of June as part of React-EU (800 million euros). Disbursements under the Recovery and Resilience Facility will be made after the commission has approved the national plans and the Council validates the commission's proposal.
Policy facilitated by central banks
It is essential that governments continue to benefit from favorable financing conditions to finance their issuance and reduce debt service. This is facilitated by the purchases of sovereign bonds by central banks.
Still very accommodative in developed countries
Application of the's strategic review
At the July 22 meeting, theimplemented the conclusions of its strategic review. This was reflected in the inclusion of the new definition of price stability: a symmetrical target of 2% in the medium term and no longer an rate close to but below 2%. It has thus changed its advanced communication on key rates. Rates will remain at their current levels, or lower, until the finds that reaches 2% well before the end of the projection period (3 years), and sustainably over the remainder of the projection horizon, and deems progress on core sufficient. In a context of rates close to their lows for some time, the will tolerate slightly higher on a transitional basis. It continues to purchase assets under the PEPP at a significantly higher rate than at the start of the year. Monetary policy will thus remain accommodating for the long term.
Fed prepares 'taper' announcement
At the July 29 meeting, the Fed said progress had been made towards meeting its targets of full employment and 2% averagebut was not yet sufficient to warrant a change of its monetary policy. Discussions focused on a possible change in the composition and pace of asset purchases when necessary.
Tightening in some emerging countries
Faced with accelerating, some central banks in emerging countries have no other choice but to raise their key rates.
Waiting for the end of the holydays
Synthetic market views: when visibility is too low
We thought that markets would remain on a wait-and-see mode and cautious during the summer and indeed risky assets have been less sought after since June. In a market whose depth is reduced in August and with significant uncertainties, the environment is not conducive to risk-taking. Moreover, after a period of optimism recovery, the clouds we had identified (delta variant, fears about the sustainability of growth, ) are increasingly a debate for the market which consequently has difficulty positioning itself on a clear direction. The degree of risk however should not be overestimated; the implied and historical volatility both remain at relatively low levels, even in a context where uncertainty remains significant.
The expected profitability/risk arbitrage is therefore currently unattractive and leads us to reduce our positions as well as our risk budget.
Allocation recommendations: reduction of the risk budget
Both the Bund and the Treasury are expected to remain stable within a narrow range. Jackson Hole, however, could give a more pronounced trend. Peripheral would tighten very marginally. Finally, on credit, we are mainly in a carry market with in slight expansion. For equity markets, a wait-and-see approach is appropriate, despite a positive reporting season, high valuations and the lack of long-term visibility lead us to expect a performance close to zero.
- The sharp drop in US yields raises questions. The T-note trades around 1.25% after the FOMC meeting and a further measured step towards a 4Q 21 tapering announcement. Neutrality prevails between 1.10 and 1.35%.
- The stepped up bond purchases in July. The Bund is trading below -0.45% as market sentiment is affected by the emergence of the delta variant despite rising growth and . We maintain neutrality.
- The BoE now seems less inclined to reduce its monetary support. The Gilt is trading below 0.60%. The BoJ sees the Japanese 10-year yield revert to 0%, which suggests a long bias.
- The PEPP strengthened, before a likely seasonal reduction in purchases in August. The new target points to an ever more accommodating policy. should remain stable.
- The long consensus remains on peripheral debt markets as Spain will cut its issuance program by € 20 billion this year.
- The RBA must deal with the epidemic resumption despite the prior announcement of the end of QE. Neutrality is generally maintained in the G10 universe despite planned rate hikes in New Zealand and Norway.
- US breakeven points are rising with successive price surprises and the Fed's wait-and-see attitude to rising . We are neutral considering the current relatively high market levels.
- In the Eurozone, increased tolerance for higher is supporting the , but valuations leave little room for performance. The dead spots should stabilize.
- In the United Kingdom, the gap between the RPI and the CPI is widening to the benefit of linker holders. The dead points are stable at a high level.
- on euro IG have changed little in recent months around 85bp against Bunds. Valuations remain a concern, as lower risk-free rates limit the universe of positive-yielding credit.
- Financial bond issuance exceeds the amounts for 2020. In contrast, the primary market is less active for the non-financial group, which is in turn well bid by the CSPP. Technical flows hence remain quite supportive.
- We are cautious on high yield. Default rates (1.8% in June) and the theme of rising stars (from BB) nonetheless mitigate the negative valuation argument.
- Most earnings publications in Q2 2021 beat the consensus with a margin of 20% on average in the euro zone. Particular attention is paid to operating margins which are sometimes squeezed by rising costs.
- The flows dried up somewhat in July. The performance of 1H 2021 motivates reallocations towards fixed income but the microeconomic situation remains very supportive and improves the valuation picture.
- Quality remains privileged, while the lack of in the reflation theme weighed on "value". Return to shareholders is improving with share buyback announcements and increases.
- Emerging USD bond increased mainly due to the US T-note rally. The EMBIGD is expected to move between 350bp and 360bp.
- Valuations are attractive, with near recent highs. The appetite for HY vs. IG is confirmed. Investor positioning is moderately long.
- Flows to the held up in July despite widening . Net issuance already represent 57% of the total forecast this year.