The expert magazine of Ostrum AM

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

  • Inflation, Delta variant: summer clouds ?

The Fed surprised the markets with a communication that is more focused on inflation: forecasts increasing and, importantly, a large majority of members seeing upside risks. The Central Bank of Canada had already reduced its QE, several central banks in emerging countries have raised their key interest rates. The Fed is therefore part of a more global trend. But the market reaction has been acute with a sharp decline in long rates suggesting that a very accommodative monetary policy exit is interpreted as a major risk to put the recovery at risk. The normalization of monetary policy, given its scale, should be even more risky than in previous occasions. The approach of this deadline and the discussions on the subject will constitute a growing risk for markets and may increase volatility. The recent calm of the markets could therefore be put in jeopardy.
We also have to worry about the Delta variant. Certainly, for the moment it seems virulent but not lethal with a number of cases progressing rapidly but few hospitalizations. The end of restrictions and the return to normal remain the central scenario. This is the bet that the markets make as if this scenario was now certain. The past has shown how difficult the evolution of the pandemic is to predict; in case of bad surprises, the return of stick to the markets could be violent.

  • Ibrahima Kobar

    Ibrahima Kobar

    Chief investment officer

Economic views

Three themes for the markets

  • life-cycle

    Delta variant

    As the level of vaccination progresses rapidly, the appearance of the Delta variant should be monitored. Its progression is rapid, even if its gravity is limited for the moment. Markets are very unprepared for bad news about the pandemic.

  • money

    Central banks

    The overall trend is towards a slow global monetary tightening. The Fed surprised with a more focused discourse on inflation. Uncertainty about current policy is expected to rise. Despite differences of opinion at the ECB, the current policy has been renewed.

  • process

    Inflation

    The rebound in inflation, particularly spectacular in the United States, is now being recorded. The debate is about its sustainability while central banks talk about transitional effects. The signals on the sustainability will remain ambiguous in the coming months, fueling the nervousness of the markets.

Key macroeconomic signposts

Business continues to grow rapidly.

  • Demand is such that production is expected to be strong until the end of the year (except for wave 4)
  • The relaxation of the constraints causes a catch-up.
  • With the perception of a lower health risk, the balance between savings and consumption normalizes
  • Fiscal policies are pro-cyclical, especially in the US while monetary policies are still very accommodative
  • In Europe, the impulse comes from the outside, causing a snowball effect on activity

What inflation risk?

  • Inflation is accelerating (1.9% in the euro zone, 5% in the US) but about half comes from oil prices

The underlying inflation rate is stable in the euro zone but rising strongly in the US

  • The divergence between the US and the Eurozone comes from fiscal policy. Very proactive in the US by targeting a sharp rise in middle class income, much less in the Eurozone where economic policy aims to limit the risk on middle class employment. This causes bottlenecks in the US, less in the Eurozone.
    The effect of the imbalances of the recovery can be seen on the price of goods excluding energy. In the US, the shortage of semiconductors limits car manufacturing. Households rush on used cars whose prices explode. In the Eurozone, there is a tension that could result from the significant increase in the price of raw materials.

Central banks

  • The question for central banks is what will happen after the euphoria of catching up.
  • Before the crisis, monetary policies were accommodating. Would growth and inflation be strong enough in the long term to justify a monetary tightening?
  • Unless measures to combat climate change are a long-term deterrent to expansion by defining a new balance towards which we should converge?
  • The central banks do not know what the activity looks like after catching up. They must remain accommodating especially if the risk of a 4th wave cannot be ruled out.

Central banks and climate change

  • Central banks do not have the same understanding of climate change.
    If the ECB wants to include it in its DNA, the US Federal Reserve is much more reserved, as is the Central Bank of China
    Taking climate change into account by a central bank requires a change in the analytical framework, the implementation of very powerful tools to influence behavior and the ability to take into account past commitments to ensure financial stability.
    The regulation put in place by the ECB will serve as a framework for other central banks that will not be able to escape the consideration of climate change.

The United States are advancing, Eurozone is beginning

  • « AMERICAN JOB ACT » : a delicate balance

J. Biden has been successful in reaching an agreement with a group of Republican and Democratic senators on his massive infrastructure investment plan, the "American Job Act" before the debt ceiling is reinstated on August 1. Initially forecast at $ 2,000-3,000 billion over 8 years, the total amount would be $ 1,200 billion over 8 years, including $ 973 billion over 5 years and $ 579 billion in new spending. However, this agreement does not mark the end of discussions as it must be validated by Congress and go hand in hand with the development of another bill.

  • European recovery plan :  new step

The European Commission has so far approved 11 recovery and resilience plans. Countries have requested all available grants. Only Italy, Greece and Romania have requested the full envelope of available loans. Italy requested € 191 billion, or 11.7% of GDP and € 30.5 billion for Greece, or 18.3% of GDP. To date, the stimulus plan has only been requested up to € 495 billion, or 62% of the total. The Council must now validate the Commission proposal in order to release the funds which could intervene at the earliest in July.

  • The corporate tax revolution

130 countries have committed to the goal of a global 15% profit tax. Beyond the trivial implications for tax optimization, the reform could have an indirect impact on international flows and external imbalances. Finally, the market balance would be disrupted: Treasury demand, pressure on the dollar and complex sectoral rotations.

Monetary policy

The wind starts to blow…

  • BCE: “steady hand”

At its meeting on June 10, the ECB said it was maintaining a "firm hand" in its monetary support for Eurozone activity. Internal dissidences had no impact. The ECB is more optimistic about the growth prospects for the Euro zone, like its GDP forecast, which has been revised to 4.6% for this year. It also reiterated that the pace of its purchases of financial assets under the PEPP will be "significantly higher". This had increased from around 17 billion euros to 20 billion euros per week. The total envelope is € 1,850 billion, of which € 1,170 billion has now been spent.

 

  • The fed is the surprise of the month…

The robust recovery in US activity prompted the Fed to change its communication at the FOMC on June 15-16, while keeping its Fed funds rates unchanged at (0-0.25%). Its projections indicate two Fed fund rate hike in 2023. The Fed has also corrected the distortions in the money market by raising the rate on its RRP facility to 0.05% as well as the rate on excess reserves to 0.15 %. Next meeting expected in Jackson Hole (end of August)

 

  • …and force hand of EMERGING markets

The acceleration of inflation and the normalization of real rates by the Fed, forced the hand of emerging central banks which raised their key rates. Their main challenge is to preserve their credibility in order to guarantee financial stability.

Strategic views

When everything is expensive

Synthetic market views: when everything is expensive

While valuations remain very tight on all financial assets, the Fed’s questions on the inflation trajectory raise concerns that support from central banks will be less proactive in the future. In any event, the debate on the exit from extremely lax policy is launched at the Fed and several Central Banks, especially in emerging countries, have begun a tightening. On the other hand, the fundamentals remain solid and very well oriented. And should justify a risk-on orientation of the markets in the second half of the year.
This is therefore a situation that is not conducive to taking strong directional bets. 

In the short term, markets should remain cautious and cautious during the summer.

Allocation recommendations: caution

We maintain a slightly bullish target on the Bund, while the Treasuries are expected to remain within their recent range. With an unchanged ECB policy and little new to expect, peripheral spreads would stabilize. Finally, on credit, we are mainly in a carry market with stable spreads, again, and marked distortions due to the ECB’s EQ. Equity markets, after a remarkable performance in the first half of the year, have limited upside potential.
 

Asset Classes

G4 rates

  1. The Fed’s change of heart on higher inflation resulted in a sharp yield curve flattening. A neutral stance remains warranted on US 10-year bonds ahead of the Jackson Hole meeting
  2. The ECB accelerated the pace of PEPP purchases despite the ongoing economic upturn and inflation close to 2%. Bund yields may continue to oscillate about -0.15%.. 
  3. The BoE adopted a more cautious stance amid a delta variant outbreak. In Japan, volatility remains very low as the BoJ amis at 0% 10-year yield. 

Other sovereigns

  1. Larger PEPP purchases are expected ahead of a seasonal slowdown in August. Investors remain overweight in peripheral debt. Italian and Spanish bonds will tighten. 

  2. The EU started its issuance programme for NextGen fund (80 bn issuance expected in 2021). EU bonds may weigh on semi-core spreads. )

  3. There is a tilt towards a reduction in monetary support. We hold a neutral stance, with however a slight preference for Australia bonds to the detriment of Norway and New Zealand markets.

Inflation

  1. US breakeven inflation rates have fallen following the June FOMC but we hold on to a neutral stance on TIPS. The upcoming tapering announcement could be unfavorable. 
  2. The breakeven term structure points to some persistence of high inflation as economies reopen and higher commodity prices feed through to consumer prices.
  3. In the euro area, neutrality prevails on breakevens despite valuations that are less stretched than in the US. 

Credit

  1. European IG spreads remain in a narrow range about 82bp vs. Bunds. CSPP was active in primary markets over the past few weeks.
  2. Net financial bond issuance has been on the rise this year compared to 2020. Issuance is well received thanks to final investor interests and CSPP for the non-financial sector.
  3. We are cautious on HY. Spreads keep tightening (likely out of a lack of alternatives).  Issuance volumes appear extremely elevated, relative to IG.

Stock market

  1. The pickup in corporate earnings should be seen in upbeat Q2 earnings releases. Annual earnings growth should reach 50% this year. 
  2. Sustained flows into euro area equity funds feed the market uptrend. However, trading volumes remain somewhat light.
  3. Growth stocks benefit from still low long-term rates. Quality outperforms whilst cyclicals may have run their course and fully priced the recovery. 

Emerging

  1. We anticipate that the EMBIGD spread will remain at levels between 330 and 345bp. The relative stability of the T-note is favorable to emerging countries.
  2. Despite the tightening, the spread is still comfortably above the lowest in recent years (close to 100 bps).
  3. Shift from Asia to Latin America due to soaring commodity prices.

Perspectives Ostrum July 2021

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  • Ibrahima Kobar

    Ibrahima Kobar

    Chief Investment Officer

  • Philippe Waechter

    Philippe Waechter

    Head of the economic research department

  • Stephane Déo

    Stephane Déo

    Head of markets strategy