Union Investment Committee reduces overweighting of equities
Moderately bullish positioning confirmed
Real returns are rising at the same time as nominal returns
Blot on an otherwise intact capital market
- Upbeat growth forecasts, corporate profits, and US fiscal stimulus remain key influencing factors
RoRo meter remains at 4, moderately bullish risk positioning
At its February meeting, the Union Investment Committee (UIC) confirmed its moderately bullish positioning (RoRo meter at level 4). In light of the recent rise in real returns, however, it has slightly reduced its weighting in equities. Even before this, the developments of recent weeks had been reflected in adjustments on the fixed-income side – with a shift away from corporate bonds and US Treasuries and towards periphery paper. The focus is therefore still on carry investments, albeit now with a different emphasis. The UIC had also reaffirmed its existing underweight position in industrial metals in February, and it did the same with its short position in US dollars (against the euro). These positions have now been confirmed again.
These recent adjustments were prompted primarily by developments in the bond market, where for some time now nominal yields have been rising in response to growing inflation expectations. This trend is now being mirrored in the real rates of return, which means that nominal yields are climbing at a faster pace than the anticipated rate of inflation. This is somewhat dampening the prospects for risk assets in an otherwise buoyant capital market environment. Indeed the higher bond yields are weighing on prices across all asset classes.
Looking further ahead, however, equities still have a lot of things going for them: economic data is generally proving to be better than expected, corporate profits are also exceeding expectations, and the new US administration’s massive stimulus package will provide an additional boost. At the same time, yields have already been on quite a run. The UIC therefore expects this momentum to tail off and wants to be in a position to respond swiftly with its available cash should opportunities arise in the short term.
Robust economic growth despite the coronavirus crisis
The economy continues to be shaped by the pandemic. The measures taken to contain coronavirus are still not allowing a return to ‘normal’ economic activity, and growth is suffering as a result. In light of these challenges, particularly in Europe, the recent economic data can be considered quite robust. The ifo Business Climate Index for Germany, for example, rose by 2.1 points to 92.4 points in February. This was mainly due to the growing optimism in manufacturing, which seemingly not even the fear of supply chains being interrupted as a result of border closures could dampen. However, the service and retail sectors did also begin to show signs of improvement. Union Investment’s economists have therefore slightly upgraded their growth forecasts for the European Monetary Union (EMU) in 2021.
In the US, President Joe Biden’s fiscal package is giving the economy additional support. There is a ‘but’, however. Firstly, the actual aid programme is likely to fall short of the US$ 1.9 trillion that had originally been proposed. Secondly, there is an urgent need for the relief bill to provide an immediate boost to consumer spending because the labour market remains very weak. The fiscal package is therefore likely to act as a sticking plaster for at least some of the lost income. The new administration’s broader spending plans will probably have a greater impact in the longer team but they will not be implemented until further down the line. So even if Biden’s approach is able to swiftly return the US economy to a steeper growth trajectory, we are unlikely to see a rapid overheating of the economy and a subsequent rise in inflation in the short term.
Overall, there appears to be greater potential for inflation to rear its head in 2021 than in the previous years. One-off factors such as the expiry of the VAT reduction in Germany and the cold snap in the US (with its impact on energy prices) have a big part to play in this, however. Union Investment’s inflation forecasts have been revised upwards slightly as a result (from 1.4 per cent to 2.4 per cent for Germany, for example, and from 0.9 per cent to 1.5 per cent for the eurozone). There have, however, been no signs to date of an inflation spiral via second-round effects or significant excess demand at macroeconomic level. Given this limited risk of rising prices, our forecasts are already factoring in a fall in inflation for 2022.
Monetary policy: no return of the ‘taper tantrum’
The overall picture suggests that real returns will not continue to surge, as happened in 2013, for example. Back then, the Federal Reserve (Fed) had announced that it would begin to wind down its programme of quantitative easing but left investors guessing as to how quickly and decisively it would do this, triggering what became known as the ‘taper tantrum’. The central banks have undoubtedly learnt their lesson from this. This is clear from the remarks made recently by key central bankers, which suggest that the central banks are very keen to support the real economy, for example by affecting ‘financing conditions’. Tapering, i.e. the scaling back of monetary policy support, is clearly not on the agenda for now.
This assessment is supported, for example, by statements made by the President of the European Central Bank (ECB), Christine Lagarde, which suggest that the ECB is keeping a close eye on a variety of indicators, including long-term nominal bond yields. It seems legitimate to interpret these statements in the sense that – like the FED – the ECB would not stand by idly if financing conditions were to deteriorate, which could be devastating for the economy. As a result, monetary policy will remain expansionary and its dampening effect on real rates of return will linger.
Yields on the increase – long-dated bonds suffer sharp price falls
Equity weighting within the asset classes
Fixed income: yields continue to rise
Yields on safe havens continue to rise. Most recently, this trend has been fuelled not only by nominal yields but also by real rates of return. Following a pronounced steepening of the US yield curve, yields on long-dated Bunds have also picked up significantly while the short-dated end of the yield curve remains firmly cemented by the expansionary monetary policy environment. The UIC believes that yields have already shifted a long way and the position in US treasuries is now extremely short. Yield forecasts of 1.5 per cent on ten-year US Treasuries and minus 0.2 per cent on ten-year Bunds are therefore likely to be reached by as early as the end of the second quarter. Risk premiums in spread segments have narrowed significantly, but could not fully offset the sharp rise in yields in many cases. In Italy, the formation of a government under former ECB President Mario Draghi has served to brighten the outlook for Italian government bonds and for bonds from the eurozone periphery overall. Periphery paper and government bonds from the emerging markets denominated in hard currencies are currently our favourites on the fixed-income side.
Equities: overweight reduced slightly
In an otherwise benign capital market environment, equities have been feeling the headwinds from rising yields particularly keenly. Higher bond yields are weighing on share prices and encouraging a rotation from growth stocks to value stocks. The (tactical) picture of capital flows and market sentiment has also turned slightly bleaker. The UIC has therefore reduced the overweight in equities from industrialised countries and, by extension, equities overall. But looking beyond the imminent future, equities remain the most favoured asset class. The latest corporate results (especially in the US) are even better than those from previous quarters and analysts continue to adjust their profit forecasts upward. Additional support should come from the fresh stimulus package that the new administration in the US is expected to introduce.
Commodities: driven by momentum
Commodity prices still have momentum behind them and continue to climb, with the sole exception of the price of gold, which has come under pressure from the rise in real rates of return. The fundamental picture in the energy segment has improved slightly in the near term due to the cold snap in the US. Temperatures well below freezing have triggered not only a spike in demand but also a supply squeeze as production at some plants has been suspended. The forward curves have improved further. However, it remains to be seen whether the OPEC+ states can maintain a united front at the current price levels. While countries such as Russia are keen to ramp up production, Saudi Arabia remains cautious. The prices of industrial metals (including quasi-industrial precious metals) continue to make gains. To a large extent, this trend is driven by the fact that the prevailing travel restrictions allowed many companies that would normally have closed for Chinese New Year to continue production. Over the course of the year, this ‘skipped’ break in production is likely to be reflected in many statistics on demand for commodities in the form of big spikes. In light of demand risks in connection with the pandemic and growing numbers of investors taking positions in this segment, we are maintaining our underweight exposure to industrial metals.
Currencies: US dollar likely to weaken again
Now that the markets have priced in the new Biden administration’s additional fiscal measures, which had pushed up yields on US government bonds, the medium-term fundamental drivers are likely to produce a resumption of the trend towards a weaker US dollar. Over the coming weeks, the greenback looks set to remain under pressure from the worsening twin deficit in the US, the Fed’s increased tolerance of inflation and the shrinking difference between real rates of return in the US and those in other countries. In the second half of the year, this trend will probably reverse again and we expect the US dollar to appreciate against the euro. More extensive fiscal stimulus measures should result in stronger growth in the US and speculation about potential interest-rate hikes is consequently also likely to start there first. However, this is still some way off.
Convertible bonds: still strong
Upbeat equity market conditions in recent weeks, especially in the US, further boosted convertible bonds. The only spike in volatility and price losses occurred around late January/early February, but any ground lost was quickly recovered. Average equity market sensitivity continues to rise and has now edged past 60 per cent. The same is true for the valuations of convertible bonds, which have now reached a neutral/fair level in all regions except Asia (excluding Japan). In addition, new issuers have entered the primary market for convertibles in recent weeks. Most of them came from the US and their placements were well received by the market.
Unless otherwise noted, all information and illustrations are as at 23 February 2021.