ECB’s tune shifts (somewhat) to hawks’ chorus

Strategy: commodities underweight closed

13 Mar 2017

  • Fed (all) clear on a rate rise this month
  • How (and when) will the ECB respond to robust growth?
  • Asia: slower credit growth in China, weak orders in Japan
  • Asset allocation: taking a less defensive stance

Developed markets fell mainly at the start of last week and then recovered despite a slightly hawkish tone from ECB president Draghi and a solid US labour market report solidifying the hawks’ case for a US interest-rate rise this week. Emerging market equities also had a positive start to the week, but then weakened. The energy and materials sectors suffered the most as crude oil prices slumped and copper fell. US two-year and 10-year government bond yields rose slightly, while German 10-year yields rose and two-year yields were essentially flat.

This recent equity market and sector performance is exposing cracks in the reflation trade, which had pushed markets too high anyway, in our view. So we have kept in place our equity underweight and used the sell-off in oil to close our underweight in commodities.


The February employment report was solid on multiple fronts, including non-farm employment, the unemployment rate and labour force participation. Average hourly earnings grew by 2.8% YoY, which is close to a cyclical high. We expect a further acceleration of wage gains as a number of sectors are continuing to report increasingly tight labour market conditions. Perhaps most impressively, private manufacturing employment recorded the single largest monthly increase in many years. One area where we may see payback is the construction sector as unseasonably warm weather contributed to strong employment gains.

Going into this week’s FOMC meeting, Federal Reserve officials will have seen February’s retail sales and inflation data. If retail sales have indeed been modest, the Fed can point to rising employment and wages. Inflation should rise further due to past increases in energy prices, but this effect should fade later this year. The core PCE, the Fed’s preferred inflation measure, has been at around 1.7% since early 2015. So inflation should be no reason for the Fed to tighten policy, but it is clear that the need for policy accommodation has lessened.

For financial markets, the main question is whether this is going to be a ‘dovish’ or a ‘hawkish’ rate rise. Market expectations have converged with those of the Fed, but markets have not yet fully priced in the median projection by policymakers of three rate rises this year. A hawkish move could drive bond yields higher and hurt interest-rate sensitive sectors such as housing and utility and REIT shares. It could even damp the overall equity market.


At their latest meeting, policymakers were not ready to remove the easing bias in the ECB’s forward guidance on interest rates because “we can’t yet say that we are there with a self-sustained inflation rate”. Thus, it seems unlikely that the ECB will be ready to announce a taper of its quantitative easing (QE) programme before September.

Still, there were hawkish hints. The ECB now sees the risks to growth as less markedly to the downside. President Draghi sees the risks of deflation as having largely disappeared, dropping the reference to the ECB using all available instruments to reach its inflation objective. Draghi was less supportive of the ECB mentioning that rates will be at present or lower levels going forward. The ECB sees no urgency in taking any further stimulative measures.

Equity markets took the ECB’s tone as being on the hawkish side. The EURO STOXX 50 rose, with banks in the lead and interest-rate sensitive utilities and real estate lagging.

The UK Chancellor did not fundamentally shift his budget strategy or the projections. However, fiscal consolidation could be hard to deliver even if everything goes well in the upcoming Brexit negotiations. After all, the Prime Minister has been less supportive of a modest rise in taxation after complaints from within her own Conservative party. Moreover, the optimistic assessment of the long-run impact of Brexit on productivity and effective tax rates may prove overly positive. Thus, there could be a lot of bad news on the UK’s public finances in the pipeline.


Bank loan growth in China is still slower than in previous years and shadow financing has also decelerated. Slower credit growth in China would be positive from a longer-term perspective. The economy has stabilised, but it remains to be seen whether it can stand on its own feet without stimulus. For now, the effects of the authorities’ stimulus measures, including a temporary cut in the tax on cars, increased fiscal spending and low interest rates, are fading.

In Japan, January’s machine orders disappointed significantly. The export-oriented corporate sector had been the strongest component in the economy, with a rising PMI manufacturing index, stronger growth in production and reasonably strong growth in export volumes. Consumers, on the other hand, have been plagued by falling real wages, leaving them cautious in their spending. One data point does not change a trend, but it is something to watch for.

We expect the Bank of Japan’s 16 March meeting to not change its official yield or asset purchase targets. There has been some stealth tapering of the BoJ’s purchases, but for us, it matters more whether it can keep 10-year yields at close enough to its zero percent target.


We have been underweight commodities since early April 2016. Since then, crude oil has rallied by roughly 30%. Overall, commodities have been less buoyant though. Nevertheless, we saw the recent sell-off in oil prices as a good opportunity to close this trade. We also regarded cyclical commodities such as oil and base metals as vulnerable. They were already pricing in fiscal stimulus and stronger growth and inflation in the US and stronger Chinese PMIs, while inventories remained high and positioning was generally long and looked stretched.

For the rest of 2017 we are cautiously optimistic on commodities. We think the US reflation prospects remain in place and the Chinese economy should not slow down imminently. This should be enough for inventories to be drawn down from the second half of the year, especially against the backdrop of more limited supply, notably of copper and crude oil. This justifies a neutral exposure to commodities, in our view.

So in recent weeks we have gradually changed our asset allocation. We are underweight developed equities, US high-yield corporate bonds and emerging market debt in US dollars. We expect global growth to be moderate and inflation to be limited, but we feel that markets have gotten ahead of themselves, leaving equities overvalued on current metrics as well as relative to what we foresee for interest rates, inflation and earnings growth.

US high-yield spreads widened last week, but not by enough to reflect the weaker fundamentals. Our view on emerging market debt is essentially the same.

However, our positioning has become somewhat less defensive. We have replaced US small caps with European real estate as a hedge for gains in risky assets and added a short duration position as a further hedge. And now we have closed our underweight in commodities.


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