The BoE Turns Hawkish?

Hawkish comments from BoE Governor Carney gave sterling a boost late last week. However, the BoE will use macro-prudential policies to cool the housing market before resorting to interest rate hikes.

The BoE Turns Hawkish

At his annual Mansion House speech, Chancellor Osborne pledged to give the BoE greater powers to regulate mortgage lending in order to remove the froth from the housing market. This would entail setting limits on loan-to-value and loan-to-income ratios to discourage excessive borrowing.

Despite being given new policy levers, BoE Governor Carney also warned that he could raise rates sooner than the markets currently expect (which was April 2015). Not surprisingly, sterling reacted positively to Carney’s comments.

Our FX strategists think it is premature to conclude that a BoE tightening cycle is imminent. While the housing market is hot, the economic recovery in the U.K. is unbalanced and inflationary pressures are muted. For example, the trade deficit is at record levels and industrial production, while up from the lows, remains 12% below the pre-crisis peak. Meanwhile, CPI inflation is back below the BoE’s 2% target and wages ex-bonuses are rising by just 0.9% yoy.

Bottom Line: The BoE will use macro-prudential policies to cool the housing market before resorting to interest rate hikes. Our F/X strategists recommend staying out of the sterling market for now.

CRE: In A Sweet Spot

Commercial real estate (CRE) is in an expansion phase, backed by favorable global economic trends.

One of the main factors that will support CRE markets globally is the return of growth. The major economies are expanding in a synchronized, if uneven, fashion. This renewed growth impetus has already begun to spill over into CRE expected returns. Like regional growth patterns, the recovery is uneven across property markets as the transition in demand from safety to growth plays out. In times of uncertainty, the trophy markets are sought for a safe and liquid income stream, but during good times, the fundamentals of the non-trophy CRE properties improve with the economy.

Another important driver for CRE is that the demand for safe havens is clearly a thing of past, with gold prices having peaked in 2011. Receding risk-aversion means that interest in riskier assets will once again fuel demand for real estate.

CRE In A Sweet Spot

The third and perhaps most important support for CRE is its link to the monetary policy cycle. Currently, easy money supports rental growth similar to how it stimulates economic activity. Eventually, tighter monetary policy will challenge returns through the higher cost of borrowing and tighter risk premia. However, real estate’s underlying link to growth shelters it, to some extent, from the early phases of monetary policy normalization as the onset of the tightening cycle coincides with an acceleration in economic activity. In other words, real estate’s net-operating income growth (NOI) typically tracks the Fed cycle. The Fed will only tighten policy in the face of accelerating growth, which should coincide with rental growth through increased tenant activity. Therefore, as the case for easy money fades, growth will support real estate returns and compensate for rate hikes in the initial phases of the tightening cycle.

Bottom Line: CRE is in a sweet spot with global growth recovering, investors’ risk appetite rising, and monetary policy supporting CRE’s return drivers. In the U.S., our CRE strategists suggest focusing on economically-sensitive non-major markets with high exposure to technology and industrials.

Resilience In The Face Of Uncertainty

The U.S. bond market has proven surprisingly resilient. Our baseline expectation continues to be a growth-sponsored rebound in real yields later this year, although a number of factors challenge our conviction in this outlook:

Resilience

  • Our cyclical bond indicators have yet to turn bearish, despite the end of the nasty winter in North America.
  • The housing and capital spending data have been on the weak side.
  • Our Global leading economic indicator rolled over earlier this year and has yet to bottom.
  • The U.S. labor force participation rate, while volatile, appears to have bottomed. This will slow the pace of decline in the unemployment rate and perhaps allow monetary policy to remain easier for longer.
  • China has failed to regain growth momentum and policymakers have been slow to ease what is an unambiguously tight policy stance.
  • Eurozone real GDP barely grew in the first quarter, reinforcing the existence of deflationary pressures and increasing the odds of an ECB asset purchase program. Expectations of Eurozone QE have spilled over into other bond markets, as highlighted by the increase in correlation among the major countries. Policymakers are considering QE, but will dither with less potent but politically more acceptable measures first.

Nevertheless, all of these factors are well discounted in the market. Excluding the term premium, the real component of the 10-year Treasury yield has fallen back into negative territory. We maintain that a growth-sponsored rebound in real yields later this year remains likely.

Gold: No Reward For Being Early

There is no compelling reward/risk tradeoff in either direction for gold prices.

Gold No Reward For Being Early

Gold and silver market positioning reveals no major extremes and plenty of mixed signals:

  • Gold: The spot price is hovering around the 200-day moving average, which itself has gone flat after falling for much of 2013. Trading sentiment is neutral at 50%. Net speculative futures positions as a percent of open interest (OI) are stuck below the 30-50% zone common during the bull market and above the 10-20% zone during last year’s washout. ETF holdings and futures market open interest have fallen substantially, but downward momentum is ebbing.
  • Silver: Trading sentiment and speculative futures positioning are oversold. The caveat is that there are plenty of “stale ETF longs”. Silver prices peaked more than three years ago at $48.55, versus $19.42 currently. Yet silver ETF holdings are close to an all-time high and futures open interest is at the high end of its four-year range.

Gold and silver prices face fundamental headwinds, but they are only slowly taking shape. Fed normalization, higher real interest rates and a firm dollar will eventually prompt new lows in safe haven precious metals.

In the interim, gold and silver could benefit from a combination of low real interest rates, higher investor risk aversion and a firm euro. Potential drivers include softer U.S. housing data, simmering tensions between Russia and the West over Ukraine, a global equity correction and/or ECB unwillingness to undertake quantitative easing despite near-zero consumer price inflation.

Bottom Line: There is little reason yet to aggressively position in gold or silver, given the absence of a fundamental trend and/or market positioning extreme.

U.S. High-Yield: Maximum Overweight

U.S. high-yield bonds remain one of the most favored sectors of our U.S. bond strategists.

U.S High Yield

Our model predicts that the default rate for speculative grade bonds will average near 3.0% during the next year. Moody’s latest estimate for the 12-month trailing default rate is much lower at 1.7%. Our view is that the U.S. and global economies will continue to expand (and recession will be avoided) over at least a one-year investment horizon. In this case, default losses could remain less than that projected by our model which is calibrated to pre-crisis macro factors. The current cycle could see the default rate move lower still given the scope of deleveraging that followed the financial crisis and Great Recession. Corporate balance sheets are in excellent shape, and there is still an ample cash cushion available to fund operations in the event of a growth setback.

We continue to monitor three key factors for evidence of a turn in default risk: our Corporate Health monitor, bank lending standards, and Fed policy. None of these yet signal cause for concern.

Other measures of credit market excess bear watching as well: investor use of leverage is rising; the covenant quality of high-yield bond issuance has begun to erode; valuation is compressed; and fund flows into corporate bonds have been firm. In aggregate, these measures are emblematic of the late stages of the credit cycle, but have room to deteriorate much further before the cycle ends.

Bottom Line: Continue to overweight high yield bonds within a U.S. fixed income portfolio.

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