The first part of 2015 has confirmed the maxim we described in our January: global economic growth remains weak and vulnerable to deflationary pressures, but investors are suddenly regaining their appetite with stronger monetary intervention imminent, this time on the part of the European Central Bank.
It would be wrong for an asset manager to deprive his customers of a particularly enterprising central bank’s generosity. Our portfolios are taking full advantage of the Draghi effect, especially through our positioning in European bonds and the dollar, as well as increased exposure to European equities.
However, our analysis of long-term global economic trends leaves us convinced that market performance will remain linked to the rarity of growth, yields, reforms, political leadership and inflation, a scarcity counterbalanced by the abundance of debt and central banks’ liquidity injections. In addition to the tactical management of equity, fixed income and currency exposure levels, this diagnosis encourages us to hold a majority our investments in the few assets that offer predictable growth and a safe medium-term return.
Scarcity of growth
It is worth remembering the circular origin of the persistent growth deficit affecting most of the world’s leading economies: over- indebtedness is thwarting the recovery of private investment as well as any strong public stimulus measures, and the weak growth that results is preventing over- indebtedness from falling. The addition of often unfavourable demographic trends means that the long-term outlook for global growth remains mediocre.
The overall trend, which to varying degrees applies to Europe, Japan, the United States and emerging markets, does not rule out mini-cycles in the meantime. For example, the eurozone will go through a growth spurt in 2015 thanks to its weaker currency, lower energy costs, cheaper bank loans and slower fiscal tightening.
Economic growth forecasts for the eurozone this year could be corrected slightly upwards, while revisions had consistently been in downward direction in the last year. However, it is still very hard to imagine growth of much more than 1.5% this year, which would be insufficient to reduce the overall level of debt or improve the potential growth rate.
It is worth mentioning also that the euro’s weakness will first and foremost benefit the area’s biggest exporter, Germany, widening economic divergence within the eurozone. In the United States, the Fed’s discomfort is palpable as it prepares to tighten its monetary policy while the rest of the world is easing theirs. Should a Fed funds rate hike need to be quickly reversed because the US economy shows new signs of weakness, this would cast doubt on the credibility of Janet Yellen’s monetary guidance.
Meanwhile, China’s growth is at best stabilising at levels half as high as those seen five years ago, while Japan’s will be no more than 1% at most, compared with 0 last year. It is important to bear in mind that in a globalised economy, eurozone growth depends on worldwide growth, and attempts at stimulus through currency depreciation are ultimately a zero sum game. A sharp drop in the value of the euro due to the ECB’s quantitative easing would export deflationary pressures from the eurozone at the expense of nominal global growth.
Scarcity of reforms
For many countries, increasing potential economic growth means undertaking serious reforms. Progress is slow, especially in Europe. A few examples:
- In France, although opinion polls showed that the public supported the Macron bill, neither the left nor the right wing of parliament had the political courage to vote for it.
- Italy’s Jobs Act was passed, but the institutional reforms needed to stabilise the government are moving very slowly and will still have to make it through the Senate in March.
- The requirement that Greece’s creditors have made of the new government to commit to reforms whose abandonment had been at the heart of the party’s winning manifesto raises the suspicion of blatant populism and pseudo reformism in equal measure.
- China’s emphasis on fighting corruption in 2014 delayed the reform programme. But at least we can reasonably hope that reforms concerning public enterprises, real estate, the environment and Hukou status will gather pace in 2015.
- The same applies in India where land purchase, mining and insurance deregulation reforms are due to be debated in parliament this year.
Scarcity of yield
Apart from the temporary drop in oil prices, global deflationary pressures result from persistently high debt, which increases the propensity to save. Added to this are more structural factors such as demographics, technological progress, globalisation, the distribution of wealth between labour and capital (Thomas Piketty would surely agree). Even in the United States, where job creation has picked up, the famous Phillips curve, which postulates that inflation automatically rises when unemployment falls, is no longer borne out by the facts. Bringing down interest rates, central banks’ massive bond buying adds to this general backdrop of disinflation.
With the ECB coming on board and the Bank of Japan continuing its intervention, these purchases will be even greater in 2015 than in 2014, despite the end of the Fed’s quantitative easing. This windfall for bond investors was unexpected and yields - already very low - will probably drop even further in 2015 with the ECB committed to buying EUR 60 billion of assets each month for at least two years, whatever the cost (an expression that comes into its own here). In this context, Nestlé and the German government have already managed to issue bonds with negative yields, guaranteeing investors a capital loss if the issues are held to maturity!
These market distortions make Mario Draghi the best friend of short-term investors in the eurozone, as he reduces the perception of risk while increasing the value of financial assets. As for us, we are being very careful to keep positions in all asset classes that balance portfolio risks, while reaping the short term benefits of this situation for our funds’ performance. Valuation levels made possible by extremely low discount rates and squeezed risk premiums are a big source of support for financial markets.
But they must not lure us into a false sense of security, as they can only last as long as confidence in central banks’ market impact remains intact. They therefore leave open the question of the exit from quantitative easing. A negative scenario, namely the admission of manifest failure of attempts at lasting improvement in nominal growth, would obviously have negative effects on credit and equity markets. Whereas a positive outcome, marked by widespread economic recovery, would see fixed income markets undergo a correction (this scenario has prompted several Fed members to call for an early hike in US Fed funds rates before the markets step in).
Although the ideal path between these two pitfalls is a narrow one, it might seem too early to worry about it while central banks remain on the move. But it seem wise to us to keep our eyes wide-open on the risks that accompany the markets’ enthusiasm at the beginning of this year. Lucidity is always too scarce.