Equity and bond markets remained unsettled last week as the fallout from the recent speeches by ECB President Draghi and Bank of England Governor Carney, which had raised the prospect of monetary tightening – or the end of quantitative easing (QE) – sooner than many financial market participants had assumed, caused bonds in particular to sell off. The market concerns about a synchronised shift in central bank policy despite generally muted inflation were compounded by comments from several FOMC members indicating that policymakers were prepared to look through shorter-term softness in US data and would strive to continue to normalise policy rates. Despite this recent uptick in market volatility, taking a longer-term view, overall volatility remains low by historical standards.
GROWING MARKET CONCERN ABOUT CENTRAL BANK REACTION FUNCTIONS
Since the financial crisis of 2007-08, central banks globally have tended to be asymmetric in their policy responses: easing policy in the face of inflation falling short of their targets more aggressively than tightening policy if inflation risked breaching their targets. Over the last few months, a number of central bankers in both the US and Europe have begun to express concerns that the currently unconventionally loose policies may be fuelling excessive asset price inflation (even though consumer price inflation continues to undershoot official targets) and generating financial market bubbles which could destabilise the financial system.
RE-RATING WOULD HIT BONDS FIRST
If the major central banks now start to shift the preferences that underpin their reaction functions towards greater emphasis on financial prudence and become more willing to tolerate a sustained period of inflation falling short of their targets – marking a sea change in their policymaking – then we would expect the first re-rating of asset prices to occur in government bond markets. This is indeed what we have seen recently: a sell-off in bonds and a concurrent rise in yields, pointing to a tightening of financial conditions.
ADJUSTING OUR DURATION TACTICALLY
Following last week’s bond market selloff, we have reduced our short EMU duration position. This move is tactical, meaning that we believe a short duration strategy remains sensible in the longer run. In the short term, however, we regard the recent selloff as overdone and we expect a correction, with yields falling back again. Moreover, the ongoing negative net supply of quality bonds – more redemptions than new issues – tends to add a scarcity premium to prices. This should increase the downward pressure on yields, especially German Bund yields.
Our other strategies remain unchanged. We think US equities are more overvalued than European ones. As the UK market is more correlated to US equities, we are overweight Eurozone equities versus UK equities. This also reflects the fact that our forecasts for UK equities are much lower than the consensus expectations.
The situation is different for real estate: European stocks have rallied significantly so far this year, whereas the performance of US real estate has been more muted. We are overweight US real estate to take advantage of this divergence, which we expect to revert over the coming months as US real estate benefits from growing demand and limited supply.
HIGH-YIELD BONDS LOOK OVERVALUED
High-yield markets look overvalued. In particular, we think they have not adjusted enough to the recent drop in oil prices and the risk of rising default rates in the US energy sector. This segment accounts for about 30% of the high-yield markets.
In emerging markets, we believe US dollar-denominated debt is overvalued relative to local currency debt. To express this view, we are overweight local currency debt versus dollar-denominated debt. This should allow us to benefit from currency gains since several emerging market currencies should appreciate from currently low levels.
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