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Impact Investing

IPE special report May 2018

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Europe edging towards rate cut

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The US Federal Reserve’s 50 basis point cut in November took the market rather by surprise, although it would have been much more of a shock had the Fed not cut at all. Investors were ready for this easing and the short end of the US Treasury market had safely priced in a quarter point.
For Roeland Moraal, portfolio manager in Robeco Asset Management’s fixed income team in Rotterdam, any interest rate cut should come as no surprise at all. “US economic data give the Fed every reason to cut,” he says. “The most recent Beige book painted a picture of continued sluggish activity. We have seen the first signs of a breakdown in the two sectors that were booming, namely housing and automobiles. There is no pent-up demand in these sectors. And although consumer spending is still holding up relatively well, the US consumer appears to be starting to crack, with September data showing a larger than expected fall.”
“The US economy is in poor shape,” agrees Credit Agricole’s Bruno Crastes in Paris, “We believe that we are still in a bond-friendly environment. However, though I wouldn’t go as far as to say that we are bearish on bonds, it is true that we are not buying on dips and are sellers of the highs. We believe government bonds are too expensive right now. And the last cut, which we believe that one was, in a cycle is always bad for bond markets.”
“At today’s level of interest rates, both short and at the long end there is so much already priced in,” comments Heinz-Wilhelm Fesser, head of fixed income for DWS in Frankfurt. “The long end has benefited greatly from the flight-to-quality over the past months and we would argue that there is even some threat of deflation priced in. That half-point cut did surprise us somewhat and we have just gone back to neutral duration having been a little bit short. But this is a short-term tactical move. In the medium term we would be underweight in terms of duration and we still prefer the fove to seven year part of the curve. The Fed has indicated a rather neutral stance from now on and so expectations might rise that this last cut might have been the last one in the cycle.”
Although bond investors may now be expressing caution as to the absolute value or otherwise of US Treasuries, there seems to be general agreement that now is not the time to be making large asset class switches into stocks. “Even if this last cut does trigger that economic rebound, who’s to say that there will not be another accounting scandal around the corner,” comments Crastes. “As to the nature of an economic rebound, it is more likely to be supply-led, that is coming from an inventory build up rather than any increase in final demand.”
“It is stocks that are driving bonds these days, and sentiment is driving the markets, not fundamentals. And that is why we are not long either, currently,” states Moraal. “We prefer to wait until fundamentals get the attention again.” For him, and his colleagues at Robeco, a double dip in the recession remains very much a possibility. “If, in the next few months the consumer does keep doing well, ie, spending, then the fundamental picture may definitely turn to the better (in terms of economics, at any rate). On the other hand, if the slowdown in the consumer which we are observing now – just look at plunging domestic vehicle sales, retail sales, chain store sales, consumer confidence and at the fading effect of fiscal stimulus and mortgage refinancing – continues, then we will see lower rates again.”
As for which side of the Atlantic holds better promise for government bond investing, it appears that Europe has the edge. According to Credit Agricole, European bonds nearly always perform better than US bonds in a bearish market, and they see little reason to expect it to be different this time. Heinz Fesser at DWS agrees, pointing out that bond yields have fallen much more than in the US and that the flight-to-quality moves, though witnessed pretty much worldwide, benefited US Treasuries more than any other government bonds.
Not for the first time, however, is the feeble economic condition of the Euro-zone an important issue for bond investors. “This year the Euro area will experience the lowest rate of economic growth in almost a decade. With fiscal policy close to the stability pact limits and global economic growth only lacklustre at best, (political) pressure on monetary authorities will grow,” suggests Moraal.
He then asserts that another rate cut from the ECB is, in his opinion, a virtual certainty, although he and his team are not prepared to pinpoint exactly when this might occur. “Whether any easing will take place at the next scheduled ECB meeting, or only after Euro-zone CPI has fallen well below 2%, is in the hands of the ECB. However a rate cut seems unavoidable.”
Fesser thinks that, once again there are arguments both for and against a rate cut from the ECB. “If we consider the basic factors which the ECB uses, then a cut is not necessary because monetary growth is above target and the last inflation figures were still above target too.” On the other hand, argues Fesser, the very subdued economic situation may mean that inflation does get lower. On balance, Fesser believes that the chances for a rate cut are now quite high.
But even though five year US Treasuries at sub-3% may indeed be rather difficult to digest, looking beyond the government bond markets the menu appears considerably more appealing. Credit and emerging markets are both getting more attention from many investors, although not without attached health – or should that be wealth? – warnings.
At DWS, Fesser argues that there is a significant risk premium now built in to the credit markets and as long as one does the requisite homework for each issue then now is indeed a good time to be moving in to investment grade credit at least.
“And we think emerging markets are a good bet right now, although you have got to pick your country carefully. We would avoid Argentina for example, but the rest of Latin America looks OK as does eastern Europe,” comments Crastes.
“Crisis expectations are pretty much priced in to the likes of Brazil and maybe even Argentina,” adds Fesser. “So it could be a good time – but go in with your eyes wide open and tread carefully!”

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