It’s All About The Yield Now

Even more of the global bond market will fall into negative yield territory, galvanizing the intense search for positive returns. The implication is that the traditional framework for projecting relative returns across sovereign bond markets based on the economic and policy outlook has been greatly diminished for the time being. Bond investing has come down to a blind, desperate search for income.

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Eurozone bonds outperformed Treasurys and the global hedged benchmark overall on the announcement of the ECB’s QE program. However, we still believe that ECB asset purchases will favor higher-yielding bonds outside the Eurozone more than it will favor Bunds. As negative nominal yields extend out the Bund curve, investors will be under increasing pressure to flee financial repression. Thus, there will be pressure for long-term global yields to converge toward a low level, independent of the relative economic dynamics.

 

Following this logic, last week our Global fixed income strategists upgraded Treasurys and Canadian bonds to overweight at the expense of Eurozone bonds, which was moved to underweight. Gilts were left at overweight versus the global hedged bond benchmark. The table above highlights that the U.S. market is a relatively high-yielder in currency-hedged terms. The European periphery, gilts and, to a lesser extent, Canadian bonds also stand out.

In unhedged terms, the U.S. 10-year bond is even more attractive, given its high yield and positive dollar trends.

Euro Area Growth: Current Consensus Is Too Low

Regardless of the ECB’s actions last week, four forces are coming together that will lift euro area growth over the next two years to a level that is well above the current consensus of 1.1% for 2015, and 1.6% for 2016.

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  • Diminished Fiscal Drag: given the improvement in structural budget balances, the need for additional austerity measures has diminished. As a consequence, the contribution of government spending to real GDP growth in the euro area as a whole should increase from 0.1% in 2013-14 to around 0.5 percentage points over the next two years. The peripheral countries should see a growth boost of around one percentage point.
  • Lower Oil Prices: The euro price of oil has fallen by almost 50% since last summer. Granted, the forward curve implies that about a quarter of this decline will be unwound over the next two years. Nevertheless, even taking this into account, the IMF estimates that lower oil prices will boost euro area GDP by around 0.9% relative to a baseline where oil prices had stayed elevated.

A weaker euro and a swing from negative to modestly positive credit growth will also propel euro area growth.

Energy Stocks: Where’s The Bottom?

Our Global Investment Strategy service argues against buying energy-related equities.

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Based on price-to-book, price-to-earnings, and price-to-sales, the energy sector looks relatively cheap today compared with 2004 (the last time that real oil prices were at current levels). That said, the prospect of significant asset write-downs, negative earnings revisions, and lower sales all suggest that these valuation measures may present a misleading view of the underlying health of energy companies.
Our sense is that while the equity and credit of these companies will present a buying opportunity later this year, investors are better off waiting for a better entry point.

EM: Beware Of Breakdown In Industrial Metals Prices

The recent breakdown in industrial metals prices in general and copper in particular is heralding more downside in EM risk assets.

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Historically, EM share prices have been tightly correlated with commodity prices in general and industrial metals prices in particular. The reason is that all of them correlate with global growth, especially EM economic conditions.

While a rise in commodities supply is certainly a major factor behind the commodities price deflation, global commodities demand is weakening as well.

We see no reason for the correlation between commodity prices and EM risk assets to change.

Our country allocation in the EM space has been positioned for a broad-based decline in commodity prices and our EM team maintains their stance: equity overweights are Taiwan, China, Korean technology and domestic stocks, Malaysia, Poland, the Czech Republic and Mexico. EM equity underweights remain Brazil, Colombia, Indonesia, Turkey, South Africa and Thailand as well as Korean autos, materials and industrials.

China Stimulus Package: Curb Your Enthusiasm

China officials recently announced that the government is accelerating 300 infrastructure projects valued at 7 trillion yuan ($1.1 trillion) this year. At first sight, that is considerably larger than the stimulus package of 2009-2010, which gave a significant boost to Chinese growth at the time. However, we doubt a re-play is about to occur.

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This time, China’s anticorruption pledges will have meaningful consequences for the speed at which investment can get done. The announced projects will be funded by the central and local governments, state-owned firms, loans and the private sector. At various levels of bureaucracy in China, officials are now far more worried about staying out of the crossfire of anticorruption initiatives than about boosting GDP numbers. This is a significant change since 2010: despite the larger stimulus numbers today, it will take much longer for investment spending to be delivered.

Our view continues to be that stimulus initiatives to date will not be enough to meaningfully change the outlook for China. The economy continues to grind away at or near 7%, which appears enough to keep unemployment in check. As long as this is the case, the Chinese government is unlikely to be forthcoming about “game-changing” growth-boosting policy initiatives.