This is the first of a series of blogs in which we will analyze the main inflation drivers that investors should consider in 2017 and beyond, as well as investment opportunities to deal with higher inflation across fixed income, equity and multi asset.
The inflation outlook has rapidly changed in the last few months and headline inflation has started to pick-up in developed markets. Continue reading
Dovish Start, Hawkish Finish
1. Slightly More Dovish Opening Statement than Expected
The second line of the press release was more dovish than expected – “The Governing Council continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases”. There had been speculation that the phrase “or lower levels” would be dropped as a sacrifice at the altar of the ECB hawks. This dovish stance was further reinforced by the statement that should the outlook deteriorate, “…the Governing Council stands ready to increase the programme in terms of size and/or duration”. This is despite the fact that the ECB’s asset purchase programme will be reduced from it’s current pace of €80bn per month to €60bn a month, starting in April 2017.
Q4 earnings season in Europe has given investors something to cheer about. 75% of companies have reported to date, and the Q4 Earnings Per Share (EPS) are up 12.1% Y/Y. This is the strongest number since Q4 2013, with 7 out of 10 sectors running ahead of consensus expectations. Outlooks for 2017 seem to be improving, with guidance from management quite positive. Earnings growth forecasts for the Stoxx 600 now stand at c.15%. Optimism prevails. However, if history is anything to go by, these forecasts may be too enthusiastic. For many, annual EPS forecasts can be more a case of fantasy, as we have seen in the past 6 years, in which expectations have been downgraded, as we moved through the year. Will 2017 be different? We do believe this year will be different, but also see current expectations as probably being too full. Our house view is that the Eurozone will experience +8.4% EPS growth, while Pan-European markets will be a little higher at +9.5%.
1. European Inflation – a Black Swan?
Some things can truly be described as rare events – the wrong film being announced as an Oscar winner and the discovery of 7 new planets being two recent examples. Last week we were able to add to that collection, with Euro-area inflation hitting the ECB’s target of 2%. Not since January 2013 has headline inflation in Europe been at 2%, but last week’s print will provide an awkward backdrop to this week’s ECB meeting in Frankfurt. All the more so since German inflation rose to 2.2%, its highest level since mid-2012. By now most people are aware that last week’s number is likely to be the peak, certainly for 2017 and possibly for longer. So where does that leave the ECB and inflation-linked bonds? Whilst the 2% print is likely to attract plenty of media attention (certainly in Germany), we believe the ECB Governing Council will look through the headline number and note that core inflation (which was unchanged at 0.9%) has yet to show any signs of accelerating. Remember as well that ECB President Mario Draghi set out four conditions the ECB needed to see to be satisfied that inflation was meeting the ECB’s target – one of those conditions was that inflation had to be “durable”, and not just one month’s number. But we are already seeing some speculation in markets that the ECB could come under pressure this week to change their language by signalling that the deposit rate has now bottomed. That could be a way for Draghi to placate the hawks on the Governing Council, who may argue that current monetary policy settings are too accommodative. In terms of inflation-linked bonds, we believe that these bonds should incorporate a premium for the possibility of upside inflation surprises. Current valuations are based on the present inflation rate, but incorporate no premium. We continue to believe that inflation-linked bonds offer reasonable value at current levels.
It has been a benign start to the year for investors. Stock markets have reached new all-time highs in the US and delivered strong positive returns across the board globally. Credit spreads in developed markets have tightened slightly, as the search for yield continues, and emerging markets (EM) asset classes have generally performed well. Moreover, the feared collapse in fixed income has not materialized. Sovereign bond yields have mainly been supported by political factors, especially in the Euro area. 10-year German government bond yields ended February little changed from year-end levels, which marks a strong outperformance over peripheral markets that have been hit by growing concerns over an anti-Euro outcome from the next electoral wave. In the US, hawkish comments from Fed members have pushed expectations for a March hike above 80%, but the effect on the long end of the curve has been limited, amid an abundance of domestic and foreign political noise. Continue reading
Posted in Economy, Emerging Markets, Equity, Fixed Income
Tagged Bonds, Bull Market, Central Banks, Equity, Europe, global economy, inflation, matteo germano, reflation, risk