SUMMARY ASSET ALLOCATION
It was the worst January for risky assets in many years, if not on record. With the US dollar hardly changed versus the euro, equities fell by roughly 6% in both currencies. Government bonds acted as safe havens with positive returns ranging from 1% in Japan to more than 2% in the US. Investment-grade corporate bond returns were flat, while high-yield bond returns were negative, although less so than for equities due to the high carry on high-yield bonds. Real estate and commodities also sold off. This raises the question of whether any fundamental factors have changed and how investors should react. We think that Chinese growth is still slowing, the global economic outlook has dimmed and markets are focused only on the negative side of low oil prices. We have increased our exposure to equities, primarily for tactical reasons.
WHAT HAS CHANGED?
The vicious sell-off in risky assets suggests some fundamentals have changed. We agree, although we also hold the view that equity markets have overreacted. Hopes that the Chinese economy was stabilising were undermined by the latest data releases. Growth slowed further to 6.8% YoY in real terms in the fourth quarter of last year and was even more modest (by Chinese standards) at just 6.0% in nominal terms. Investment and industrial production slowed towards year-end, while the manufacturing PMIs held firmly below 50 in January.
Amid large capital outflows, the Chinese currency remained under pressure in early January. We would not be talking so much about China if the rest of the world was doing well. But growth in the US slowed to only 0.7% QoQ annualised in the fourth quarter as the economy suffered from slower consumption growth and drags from business investment, net trade and inventories. Weakness in the manufacturing sector is not new, but signs that this could be spreading to consumption have rendered the US outlook less positive. In the eurozone, leading indicators may now have rolled over, but the real data has disappointed lately.
Monetary policy: changed perceptions
The equity market plunge has had a profound impact on monetary policy expectations. In the eurozone, ECB president Draghi strongly hinted at new measures at the March policy meeting. This time, Draghi repeatedly said that the ECB should review and possibly reconsider its stance next month. He dismissed the possibility of overplaying his hand again, as he did in December, by insisting that the ECB’s line of communication was unanimous. A further cut in the deposit rate looks like the least controversial option since the resistance to a deeper cut than actually delivered in December was not that strong. But after Draghi’s latest hints, changes to the ECB’s asset purchase programme are also possible.
The Bank of Japan surprised in late January with a cut in the deposit rate into negative territory. Only shortly before the meeting, BoJ governor Kuroda had ruled this out. Equities rose on the news and 10-year bond yields fell to a record low of only 4.4bp. We expect the impact on the economy to be limited. Due to a three-tier system, the negative rates will only be applied to a fraction of bank reserves. As these reserves rise due to the BoJ’s quantitative easing, more of them should fall under the negative rate regime, but the second tier of the system, where the applicable interest rate is zero, can be raised. The BoJ did not rule out further cuts, but it will be careful
not to hurt bank profitability too much.
Can the US Federal Reserve raise rates when the ECB and the BoJ are easing? Policy tightening in March looks increasingly unlikely. The market-implied probability of a
hike has fallen from more than 50% to just 20%. In the press statement after the January policy meeting, the Fed had said it was “closely monitoring global economic and financial developments”, signalling its concern over those developments.