“Their valuations are now high and represent a risk under numerous scenarios. Assuming that the situation worsens in Europe, the risk premium could rise on the highest rated countries, such as Germany. In fact, Germany is already de facto linked to the fate faced by certain countries, particularly though its banks’ more than euro 700 billion in liabilities with the ECB through the Target2 system,” DAM in its outlook said.
Otherwise, it added, current yields already price in a large portion of further monetary easing and could rise in the event of a more favourable shift in economic scenarios.
“Our favourite stories are still defensive and growth-oriented”, Koen Maes, head of asset allocation strategy, said.
“We are also overweighing high-yielding stocks (while remaining selective), which have been made even more attractive by falling interest rates. We also reiterate our positive view on convertible bonds, which offer attractive carry and equity market exposure in the event of a market rally and are attractively priced.”
The lull created by the central bank’s two LTROs didn’t last long, producing only a quarter-year of gains in all asset classes, including equities, bonds, and oil, and others. As the year began, the impact of increased liquidity was in full display and was strengthened by encouraging trends in macroeconomic indicators. Enthusiasm has now receded as central bank balance sheets are no longer expanding, as economic figures are worsening in worldwide, and as dissension among European officials has moved back to the fore. That said, are we replaying the scenario of last year?
Half-years go by, and questions remain. The environment is much like it was last year. The index of economic surprises has taken the same downward path as last year, and the European sovereign-debt crisis is getting worse. However, we also see many clear differences.
Financial market declines have been relatively orderly, with, thus far, no panic. The risk premium has risen steeply for the riskiest assets. Risk has not become systemic; a clear distinction is still being drawn between risky assets and less risky ones; our market indicators (e.g., risk appetite and volatility measures) have not spotted any overselling. This is a seeming paradox.
For, the situation in Europe has worsened as one crisis has come on top of another. This spring, a point of no-return was reached on Greece, as talk of the country’s exit had moved from the realm of impossible to the realm of possible within two years, although the degree of probability remains low in the near term. Spain is also facing a banking crisis that it will be unable to resolve without outside help. With political crises and banking stress erupting against a backdrop of economies plunging into recession, drastic austerity measures are now being denounced.
“Investor pessimism could ultimately be good news from a contrarian point of view. Positioning on equities, European ones in particular, hit lows in late May 2012. This run-up in stress levels could play a positive role if clear and credible responses are quick in the coming,” Nadège Dufossé, a strategist, said.
The stabilisation and the recent gains in the financial markets have been driven by some reassuring news and lots of hope. Investors are pricing in easing measures in China, the US, the UK and, as a last resort, the ECB. Barring an improvement in fundamentals, the market is still closely tracking liquidity trends, which are still one of the main upside catalysts. For this, the international context is far more favourable than last year. A receding in inflationary pressures has given China the leeway to stick with the monetary easing measures it has already launched. The Fed could intervene more aggressively in September if the threat of fiscal consolidation and a lacklustre job market pose too great of threat to growth prospects. New measures will be taken in the euro zone only as a last resort. However, since December 2011, the ECB has shown more pragmatism and has enhanced investor confidence in its actions. Monetary easing measures are also being priced in by the markets, but it is hard to see to what degree this is responsible for market gains.
For the gains to be more sustainable, the risk premium will have to decline more structurally, particularly in Europe. And this can only be achieved with clearer signs of a reduction in uncertainty and risk in the euro zone. Among the plans being discussed, we see some worthwhile measures like the European Redemption Fund (ERF), a banking union, and a European deposit guarantee. Any progress towards greater fiscal integration (such as the ERF) or partial abandon of sovereignty (the banking union could be a first step) will take time. If we are expecting concrete progress in these areas we will probably be disappointed by the coming summit.
“A clearly expressed common determination to keep the euro zone going, and a credible action plan to resolve the current problems could restore some confidence and help lower the risk premium. An easing in austerity restrictions in certain countries and the adoption of pro-growth measures could also support an increase in valuations,” Nadège Dufossé, said.
The situation is still precarious. Any excessive disappointment could send us into a new cycle of stress, which is the main driver of negotiations in Europe. The psychological battle between countries is feeding the rumour mill and heightening market volatility.
Another story is playing out on other continents. Our 2012 scenario assumes a decoupling between the growing US and emerging markets, on the one hand, and Europe, which on the whole, is in recession, on the other hand.
“We are overweighting other geographical regions, such as the US for more structural reasons, and China, which is well placed to ride a cyclical rebound,” Nadège Dufossé said.
Our positive recommendation for the US is more structural in nature. Since the crisis began, the US has established a more solid basis for growth in the future. It is further along on deleveraging than other countries; its real-estate market is approaching bottom; its cost competitiveness has improved drastically and is likely to allow the country to benefit from the best growth opportunities. The shorter-term risk is of hasty fiscal consolidation. New monetary measures could help the US weather this stage, if necessary.
In contrast, DMA sees China as a cyclical rebound opportunity. Monetary and fiscal easing has begun and should help stem the economic slowdown in the second half of the year. In the longer term we remain cautious on the country’s ability to manage a transition towards a domestic-demand-driven economy. Moreover, potential official intervention to support growth is limited not by financial resources but by the lessons learnt after 2008 and 2009 of misallocation of resources.
The correction has widened the valuation gap with bonds to historic levels. The current phase of stress, which is why we are currently slightly underweighting risky assets, is likely to be followed by a receding in risk aversion in our base-case scenario. We will refrain from taking overly aggressive positions, pending truly credible responses in Europe.