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
- A central bank dilemma
Despite the recovery, the economy is far from its potential and the unemployment rate remains high. Central banks must therefore pursue their very accommodative policy to support the rebound in activity and the normalization of the economy. Inflationary pressures are on the rise and spreading to many sectors, expectations are even beginning to reach high levels, at the same time production is unable to keep up with the rebound in demand and overheating situations are emerging. So central banks have to start reducing their support.
A classic dilemma for central banks at this point of the cycle is between the risk of tightening monetary policy too early and, conversely, the risk of lagging behind and generating speculative bubbles or overheating activity. What is not traditional is the colossal scale of monetary easing last year that reinforces the risks of this dilemma. Uncertainty on the path of monetary policy is beginning to generate volatility on markets in the wake of tapering discussions in the US and PEPP reduction in Europe.
The markets has anticipated a lot of good news and seem to us richly valued. Their muted reaction to the runaway economic data and the very good reporting season validates this view. With the economy still accelerating, we must remain optimistic, especially in the medium term. But in the short term it is necessary to be much more careful and a market pause seems plausible to us. In this context, a premature withdrawal of central banks support may be difficult to absorb.
Three themes for the markets
Over the month of June a large part of developed countries should reach a significant level of vaccination. This would allow a widespread deconfinement. The lag in some emerging countries remains a problem that can weigh on the recovery.
The overall trend is towards a slow global monetary tightening. The Fed should announce a tapering after this summer and implement it next year. Differences of opinions at the ECB may lead to less activism of the PEPP, the meeting of 10 June is to be monitored.
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
- Since the beginning of the year, the dynamic of world trade has grown rapidly. During the first quarter, these exchanges increased by almost 7% compared to the first three months of 2020. This is a pace that had not been observed since the financial crisis of 2008/2009.
- Both Asia and China are pushing these trade upwards, while the US recovery contributes more to global trade growth.
- In Europe, this Chinese dynamism can be seen in the evolution of China’s contribution to German exports. Much reduced until the end of 2020, this contribution accelerated sharply, approaching what had been observed during the post-financial crisis period. We must see in this impulse, to which is added that of the rest of Asia a major explanatory factor of the recovery of the Eurozone. The other factor is the exit from lockdowns. This has been brutal in the USA through job creation, it is also very noticeable in Europe.
There are therefore two sources fueling economic optimism, catch-up after containment and support for recovery plans.
- This more robust activity in Asia and Joe Biden’s stimulus package associated with the broad-based U.S. vaccination plan led to the turn of events in the spring. Wait-and-see has given way to optimism. That’s what the surveys say. The gains are remarkable, reflecting the effect of the recovery in world trade on the manufacturing sector and the ripple effect on services, which are growing rapidly this spring. Spring GDP figures will be strong in the Eurozone.
- The faster than expected growth in economic activity raises questions about the possible resurgence of inflationary pressures. This is not yet true despite the sharp acceleration of US inflation in April. Consumer prices rose by 4.2% and the underlying inflation rate by 3%. This figure can be misleading as it compares current prices to those of last year when the US economy was in lockdown. The price of oil had collapsed. The second graph shows the large-scale correction on its price in April 2021. Other factors had an impact. This is the case, for example, for semiconductors, whose insufficient production resulted in an unprecedented increase in the price of used cars (since new cars were not available). So there are exceptional factors in April that should not be extended.
- On the other hand, the question is about wage pressures that could intensify in the coming months. Businesses want to create jobs, but the participation rate remains low. In other words, people who left the labour market during the health crisis are not rushing back to work. If the phenomenon were to continue this would result in upward pressure on wages and the risk of a slightly higher inflation rate. This observable phenomenon in the USA will soon be noticeable in Europe.
- For central banks, the question is about the sustainability of the recovery and inflationary risk. The answers are differentiated. In the US, Fed members seem to agree on a return to normal with higher interest rates to facilitate the balance of capital markets but without paying particular attention to inflation since this is no longer its main objective. In the Eurozone, the ECB is more cautious about the sustainability of the recovery. This will quickly lead to a reduction in asset purchases by the Fed while the ECB has no reason to accelerate the movement especially as inflation expectations are still limited.
Governments mustn’t withdraw support to the economy
Collossal fiscal stimulus in the United States
The barely ratified massive stimulus package of $ 1.9 trillion, including direct transfers to US households, was followed by the announcement of two broad programs designed to boost growth and jobs and reduce inequalities. The infrastructure plan (of $ 2,300 billion) would be financed in particular by an increase in taxes on businesses and the plan for families (of $ 1,800 billion) by taxes on the richest households. Discussions promise to be intense in Congress.
European recovery plan : not yet
To date, 18 countries have presented their final recovery and resilience plan to the European Commission in order to benefit from the first payments from the European Union during the summer and this until 2026. The latter must meet a certain number of criteria, particularly in terms of spending in the energy transition, digital transformation and reforms. While all countries have used the grants, only Italy and Greece have requested all available loans. Success will depend on the effective implementation of the measures.
Policy facilitated by keeping interest rates low
Governments have had to extend aid to households and businesses due to the impact on activity of the Covid resurgence at the start of the year. It is essential that they continue to benefit from favorable financing conditions to finance their issues and reduce debt service. This is facilitated by the purchases of bonds by central banks.
Very accommodative central banks in developed countries
BCE: meeting on 10 June eagerly awaited
The June 10 meeting will be the key point for financial markets. The ECB will deliver its new outlook for growth and inflation and decide on the pace of its purchases of financial assets as part of the pandemic emergency plan (PEPP). It had decided last March to speed it up for 3 months in order to ensure the maintenance of advantageous financing conditions. Since then, verbal interventions by central bankers have revealed a certain difference of opinion within the Board of Governors. This meeting will be an opportunity for the ECB to send a clear message to the financial markets on the need to maintain a very accommodative monetary policy.
The fed: towards a tapering announcement
Recent statements by members of the Fed have emphasized the temporary nature of the sharp acceleration in inflation and the fact that tapering, i.e. a slowdown in the pace of asset purchases by the Fed, was premature at this stage. Nonetheless, discussions on the subject are likely to begin, as the last Fed Minutes suggest, with a possible announcement at the Jackson Hole meeting in late August.
Adjusted monetary policy in some countries
Some central banks have already started adjusting their monetary policy as activity picks up. In particular, the Bank of Canada and the Bank of England have decided to reduce the pace of their purchases of financial assets.
The Fed calms down markets
Synthetic market views: continuation of horizontal consolidation
US 10-year rates range from 1.55% to 1.70% pending a clear signal from the Federal Reserve. The minutes of the April FOMC confirm an upcoming reduction in asset purchases but the interventions of the central bankers manage to contain the volatility. The ECB holds a similar speech before its June meeting. Credit markets remain stable and there is horizontal consolidation in equity markets that digest a season of historic earnings.
The next monetary decisions seem to take precedence over the economic data, which are much more favourable in Europe.
The reduction in overall volatility and the valuation levels of risky assets, pending a new monetary orientation, do not encourage strong positions.
Allocation recommendations: discriminant
The increase in yield on the Bund encouraged us to neutralize our exposure sensitivity. Sovereign spreads have decreased but remain subject to the next ECB communication. The IG credit, particularly the crossover, benefits from the rating enhancements in the recovery but the valuations remain generally unattractive. Equity markets take advantage of the post-release period with no trend to engage in large rotations.
- The Fed’s denial of inflation helps keep the T-note below 1.70%. Neutrality seems to have to prevail over the 10-year US in the expectation of a Fed signal, probably around Jackson Hole.
- The ECB is seeking to alleviate the upward pressure on the Bund, which is justified by the improvement of short-term surveys and rising inflation. Level below -0.20%, could offer sell opportunities.
- The BoE communicated a gradual reduction in its online purchases with the reopening of the economy. In Japan, volatility is minimal given the 10-year targeting policy.
Net emissions (post QE) will be negative overall, but deficits are deteriorating in Italy. This leads to more caution on peripheral debts.
The implementation of the European recovery programme will weigh on semi-core securities, particularly on long maturities.
There are increasing signs of a reduction in monetary support (Canada, Norway, New Zealand). However, these movements are well integrated by the markets.
- Breakeven periods include a cyclical increase in inflation linked to industrial and now agricultural raw materials. Neutrality prevails over breakevens.
- The level of break-even points appears to be consistent with the momentum of recovery and consumer potential, given available savings.
- In the short term, inflation surprises are expected to remain upward in the United States. The gradual withdrawal of monetary support will then be accompanied by an increase in real rates.
- European IG spreads have been in a narrow range and decreasing since the beginning of the year. The CSPP maintains a low volatility environment.
- Financial issuances are up from last year, but are well received with final interest and CSPP.
- We are cautious on the HY. Spreads are reduced after 50 bps of tightening in 2021 especially as the volume of issuances remains very high unlike in the IG space.
- Valuations improve at the margin, but reduced volumes are a focus, while annual performance targets are already met.
- The fundamentals are good, the Q1 results publications are very well oriented. The market will again focus on macroeconomics and monetary decisions.
- The growth theme benefits from any downward reversal in rate but the flows indicate that investors still prefer value. Sectoral rotations are brutal.
- 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.
- Despite the tightening, the spread is still comfortably above the lowest in recent years (close to 100 bps).
- Nevertheless, it is necessary to be discriminating in terms of investments. We are particularly positive in Asia where the economic rebound is stronger.