Edison Investment Research

ECB: Next ECB President must keep up the pace of change.

Absence of a crisis risks a slowdown in pace of eurozone financial sector reform

Author: Alastair George

In only a few weeks, European leaders will have to decide on a new ECB President to replace the incumbent Mario Draghi, whose term expires in October. Draghi has been a radical ECB president, deftly playing a difficult political hand to win support for a EUR 2.5trn ECB balance sheet expansion. In a time of crisis he offered “whatever it takes” to save the euro. We can now believe his claim that he would do enough to restore financial stability to the eurozone. Yet the ECB’s work in terms of monetary policy, regulation and eurozone financial integration is far from complete. Unlike Draghi, the incoming ECB President faces no immediate crisis. However, politically challenging further convergence of fiscal trajectories, economic growth and bank sector regulation is required to ensure the long-term viability of the eurozone project.  We believe markets would applaud an ECB President offering policy continuity in the short-term combined with the experience and political skills to ultimately drive further eurozone integration.

ECB: Buy the rumour, sell the news.

Markets had run ahead of ECB’s policymaking; valuations suggest near-term rally complete

Despite the ECB’s policy action yesterday, which pushed out the date of the first interest rate increase and confirmed a substantial package of targeted bank financing intended to ease credit conditions for the corporate sector, the market reaction was largely negative. Yet a key part of our bullish call in January was that equity valuations had retreated to levels which were close to long-term averages, a relatively unusual occurrence in this economic cycle. Since then, equity valuations have rebounded sharply as markets have risen while 2019 consensus profits estimates have fallen. This was largely in anticipation of easier monetary policy in our view. We now expect markets to trade only sideways in the absence of a near-term catalyst, while awaiting evidence of a turn in the economy during Q2/Q3. In respect of a US/China trade deal, the apparent cancellation of the Xi/Trump summit due in late March is however unhelpful for sentiment.

Market outlook: balanced but still biased to upside.

Impact of lower rates, China tax cuts and political progress likely to be evident by mid-2019

Weak incoming data, both in respect of profits forecasts and the global economy is in sharp contrast to the strong performance of risk assets such as equities and corporate credit during 2019. Conflicting narratives can certainly create angst but in this case reflect investors’ belief that central banks have acknowledged the slowing global economy. We would concur that easier financial conditions means relief from negative economic surprises may be in sight by mid-year. Despite having risen sharply in the first few weeks of the year, on balance we believe global equities now have the prospect of volatile but still upward progress, as political events unfold.

Global earnings revisions still on a downward trend.

Equities bridging a gap in corporate performance - for now

Consensus profits forecasts on a global basis remain on a downward trend even as January’s recovery in risk assets such as equities and corporate debt continues into February. The primary reason for this at first sight paradoxical state of affairs is not hard to find; the US Fed has placed interest rates on pause and acknowledged the slowing of the global economy. Nevertheless, the clock is ticking on the persistence of the current profits downgrade cycle, which is also consistent with economic weakness evident outside the US. While not shifting our neutral stance on equities for the full year, near-term market performance is now in our view more tightly bound than usual to the turn in the direction of global profits forecasts. Therefore, in the short-term we would not chase the rally, at least until there is some evidence of stabilisation in earnings or positive news in respect of US/China trade.

ECB fiddles as eurozone turns.

Compared to US Fed, ECB seems flat-footed as growth slows

During the recent period of market volatility the US Fed has in our view successfully re-positioned itself on the doveish end of expectations, both in terms of interest rate and more recently balance sheet policy. The ECB in comparison appears flat-footed, with ECB President Draghi failing to use the opportunity in his press conference last week to emphasise policy flexibility in the event of a downturn. Ironically, the most recent disappointing incoming data is concentrated in the eurozone, rather than the US.

Economic survey data on a weakening trend outside US.

The fly in the ointment for investors trying to look through political developments

Following a difficult autumn, investors are likely to be weighing whether 2018’s risks are almost in the rear-view mirror. Brexit could conceivably be settled by January, with minor changes to the Withdrawal Agreement; the Italian budget stand-off could be resolved by a telephone call. In terms of financial conditions, the Fed may raise rates in December but could guide to a pause, reflecting economic or market turbulence. Similarly, the ECB could acknowledge that the weakening trend in eurozone data warrants a continuation of QE, or at least some very doveish forward guidance.  Finally, following the mid-term elections, rebel Trump’s politically motivated trade war on China is now without a cause, at least in the short-term. Speculation of a US/China trade “deal” at the upcoming G20 meeting in Argentina is rising, which could perhaps at least represent a cease-fire in hostilities. Such a shift in sentiment may seem far-fetched, but should at least be considered alongside more bearish scenarios.

2019 Earnings forecasts softening.

October market declines coincide with falls in non-US 2019 profits outlook

In recent consensus earnings revisions, we see a modest acceleration of downgrades to 2019 UK and continental European profits forecasts which have been drifting lower since August. In contrast, US forecasts have been revised only fractionally lower. The real action is in emerging markets, where 2019 forecast profits growth has fallen from 15% as recently as August to only 11% today. Finally we note that the typical upward trends in analysts’ target prices has stalled during 2018. This in our view confirms our top-down perspective that higher interest rates have been feeding through to company valuations, even as profits continue to grow.

Rising US bond yields spark volatility breakout.

Synchronised declines in global equity markets may help stockpickers

October’s sharp declines in equity markets are being attributed to rising US bond yields. However, the surge in volatility is similar to that seen in January and raises questions about an underlying weakness in equity market depth rather than any radical change in fundamentals. It was hardly a secret that bond yields were likely to rise further over time given the strength of the US economy. Furthermore, a quarter-point increase in US 10y rates to 3.25% is not an especially large move. Recent increases in the US 2y rate perhaps went against the grain of Powell’s August comments but again were not especially noteworthy. We believe investors should first ensure that portfolios are appropriately positioned from a risk perspective, given the likelihood of a higher volatility trading environment.  Second, investors should be actively looking for securities which have been unfairly discounted in what has been an indiscriminate sell-off. However, we do not feel it is time to change our cautious stance on developed equity markets in general.

Global implications of rising US yields.

Tighter monetary policy and larger US fiscal deficits point to higher yields ahead – and a higher risk premium for emerging markets

Events in Italy may have highlighted a crowded short position in long-term bonds, with US 10y yields falling by 0.25% to 2.75% during a week of political uncertainty. However, US bond market investors still have to contend with rising short-term interest rates and a substantial increase in the issuance of US Treasuries to finance Trump’s tax reform. Furthermore, this is happening at the same time as the US Fed attempts to reduce the size of its balance sheet. Current 10y yields appear too low in the context of a continued economic expansion and emerging market policymakers are becoming concerned.

Long hot Italian summer.

Likely September elections may be a referendum on euro and EU membership

Italy’s failure over the weekend to form a government was driven by the refusal of the Italian President Mattarella to appoint the hardline Eurosceptic Paolo Savona to the position of economy minister. From the perspective of President Mattarella the recent election was not a referendum on the euro; for the Five Star/League coalition his refusal to accept Savona was interference in the democratic process. An incoming caretaker government is being put in place but is not the issue; elections later in the year will in effect be the referendum on the euro. For investors, this creates significant uncertainty over the summer months and into the autumn.

Italy: Political risk strikes (again) in eurozone.

Political power and resolve of EU and ECB should not be underestimated (again)

The prospect of a populist Five Star/League coalition government in Italy has spooked Italian bond markets with yields soaring in recent weeks. Nevertheless, this price move may still be viewed in the context of a correction, given the clearly large difference in fundamental credit quality between Italy and Germany, both from a political level and as measured by the government debt burden as a percent of GDP. It is a situation which is likely to create investor anxiety but the precedent of Greece suggests that the ultimate political power of the EU and ECB is considerable. An “Italexit” scenario would create a high degree of market uncertainty but remains low probability in our view.

2018 Earnings forecasts: Still robust, for now.

Corporate sector soldiers on despite increasing geopolitical tensions

Geopolitics will in our view continue to present headline risk for the rest of the year. The US/China trade détente has broken apart as the US administration addresses the prospect of China challenging for dominance in the world economy. This weekend’s military response to the use of chemical weapons in both Salisbury, UK and Syria may for now be described as “mission accomplished” but it remains to be seen what the response would be to any further provocation. At the same time, there has been a run of disappointing economic data in the eurozone. Nevertheless, earnings estimates remain relatively stable for now in aggregate as the recent strength of the oil price leads to upgrades in energy, offset by modest downgrades in other sectors.

2018 Earnings forecasts: US stable, modest declines in Europe.

Watch for ebbing economic momentum as survey data peaks

Despite the increase in equity market volatility, there has been little follow-through to economic fundamentals to date. US earnings forecasts have stabilised and are indicating mid-teens profits growth for 2018, of which approximately one-half appears to be due to US tax reform. US economic surprise also remains relatively strong. In Europe however, unweighted earnings estimates have continued to fall, if modestly, and perhaps more importantly here economic surprise indices have turned sharply lower. We view this as partly due to Brexit uncertainty in the UK and a rising EUR exchange rate in continental Europe.

Rising bond yields: Mini-drama perhaps, but not a crisis.

Rising yields a ‘known’ risk – declining economic momentum would be a bigger concern

This week’s modest declines in equity markets may be the largest of the last nine months but that is only an illustration of just how far equity market volatility has fallen. The narrative of rising bond yields and inflation expectations is being used to explain the market declines. This is understandable and we ourselves have previously highlighted the anomalously low level of global bond yields. However, rising yields are a known risk for 2018 and unlikely to create a major sell-off in equity markets by themselves. We would be more concerned if there was firm evidence of a meaningful slowdown in economic momentum. Such evidence is - for now - largely absent in either Europe, the US or China.

Canaries in the monetary coal mine?.

High profile difficulties in a hot corporate debt market are intriguing

Steinhoff and HNA Group are from different regions and sectors. Yet they are making the headlines for the wrong reasons as the market raises questions over their debt sustainability. What these firms do have in common is that have pursued a policy of debt-financed acquisitions during this cycle. Now, LIBOR rates are pushing markedly higher. These signals of tightening credit bear watching in our view, even if they are presently not a cause for immediate alarm. It is however our important to be alert to early signs of a turn in credit availability. This is likely to first occur at the margin of the credit risk spectrum, as in 2007/8.

Valuations: An important part of the puzzle.

Price/book multiples highlight worrying trend in risk appetite

In this cycle valuations have been, so far, the dog that did not bark. Globally, the median sector price/book multiple has risen from the trough of 2008 to a new peak. Such an expansion in market valuations is similar to that seen in the 1980-1987 period. Between 2012 and today we have come full circle in terms of tactical asset allocation. Earlier, we could not understand why investors were so uninterested in adding risk to portfolios despite such high expected returns in equities. Now, equity valuations suggest only modest long-term returns are on offer and there is greater prospect of short-term disappointment. It is however proving equally difficult to attract investors’ interest in this signal for caution. Perhaps the metaphorical - and silent - valuation dog knows the psychology of the current marginal investor rather too well.

Government bonds in the firing line.

The next twist in the story is likely to push global yields higher

It is always important to put aside preconceptions and let all the data speak – and not just that which confirms prior beliefs. At present, the data which best models the long-term outlook (valuations) are suggestive of relatively weak returns in global equities and this has informed our cautious positioning. Furthermore, bond yields and interest rates remain unusually low on a historical basis. Yet for the short-term, economic surprises are currently positive, business sentiment strong and profits growth relatively robust. It is this short-term data which also needs to be heard.

Economic data surprising to the upside in Q3.

Strong PMI indices add weight to the case for tighter monetary policy

While valuation concerns for equity markets remain in place, recent economic data in the US and eurozone also points to something of a mini-surge in economic momentum over the last 3 months. PMI data has been coming in ahead of expectations and economic surprise indices have turned higher in all regions. During 2017, investors have had to balance their longer-term valuation concerns with generally robust profits growth and improving economic sentiment. While soft data such as PMI indices should not significantly shift portfolio asset allocations, a hiccup before the end of the year is now looking less likely.

US rates: Has the fuse been lit?.

Conditions for synchronised, if gradual, tightening of policy appear in place

To our surprise yesterday’s Fed statement and projections not only re-confirmed the probability of a rate increase later in the year but also continue to forecast three further rate increases in 2018. Furthermore, the Fed announced the pace of reduction in its balance sheet which, while an initially modest US$10bn per month in October will rise to US$50bn per month by the end of 2018.  The initial market reaction has been for the yield curve to flatten further as investors price in an increased probability of a Q4 rate rate increase while US 10y bond yields rose by only 3bps. Equity markets may be sanguine for now but we view this monetary headwind as a slow-burn fuse which may challenge investors again during 2018.

Interesting times for central bankers.

If growth is picking up, why are bond yields still so low?

It appears the low volatility/high valuation regime in equity and credit markets is continuing into the autumn. This is despite an important and imminent US Fed balance sheet reduction announcement. Furthermore, October brings details of the ECB’s plans to reduce the net purchases of its own QE program. While central bankers are quick to claim credit for any improvement in economic conditions, the decline in long-term bond yields over the summer questions the durability of the expansion as the yield curve flattens. It also remains to be seen if investors will re-appraise the low level of risk premia in global markets as QE is withdrawn.

Fed policy: Don’t forget your flip-flops.

US inflation and growth numbers undershoot expectations

It is just a few weeks since the US Fed raised interest rates and central bankers globally opined on a removal of monetary accommodation (albeit slowly) as the global recovery gathered momentum. Unfortunately, some inconvenient facts are already casting their shadow. The Atlanta Fed US GDP nowcast for Q2 17 has fallen to 2.4% from 4% at the start of June, with disappointing US retail sales contributing to the downgrade. Furthermore, core CPI has undershot expectations with the year-on-year figure now at 1.7% for June, compared to 2.3% at the start of the year. Fortunately for central banks, the holiday season has started and the focus may be elsewhere. However, some re-calibration of the trajectory of US monetary policy may already be necessary.

A tipping point as monetary policy shifts.

Central banks on both sides of the Atlantic appear to be becoming more hawkish

In recent weeks, policymakers at each of the US Federal Reserve, Bank of England and ECB have become notably more hawkish. This is a new development as throughout the period 2010-2017 central bank balance sheets have been steadily expanding as the quantitative easing (QE) baton was passed around the globe. With asset prices rising strongly over this period many commentators have been quick to infer that the end of QE signals market trouble ahead. While certainly a headwind, we believe investors should not rush to judgement. There remain many acts to play out in this story before it is finished.

Equity risks are rising: economic surprises turning lower.

Economic surprise turns lower and positive earnings momentum easing in Europe

We are viewing with increasing concern the building evidence of disinflation in industrial commodity and energy markets. Economic surprise indices have turned sharply lower on a global basis, a move which cannot be fully explained by seasonal factors. In this context we were surprised by the relatively hawkish recent policy statements by the US Federal Reserve and Bank of England. For the US Fed, it was very much a case of one and not done at the recent FOMC meeting, where US rates were increased again. For now, earnings growth forecasts near 10% for each of the US, UK and continental Europe remain intact but we also detect ebbing momentum in this data compared to 6m ago.

Fed rate decision: One and done - or not done?.

One and not done would spook markets in our view

On Wednesday 14 June, we believe the US Fed is highly likely to raise the target range for the federal funds rate by a further 0.25%. We believe the opportunity the move policy rates further away from the zero “lower bound” will not easily be passed-up as US unemployment figures improve and as importantly without spooking markets, which have priced this move in. However, a signal of “one and done” for 2017 – or at least “one and wait and see” will be critical to keep markets buoyant. In addition, investors will be watching for benign comments in respect of any adjustments to the Fed’s balance sheet policy.

C’est l’économie… French and German bond yields diverge.

It’s not the unlikely election of Le Pen, it’s the economy ...

The recent divergence between French and German government bond yields has been widely attributed to a possible victory for the anti-euro Marine Le Pen in the French presidential election. In our view this is not the whole story. The widening gap in terms of borrowing costs also mirrors the increasing economic divergence between France and Germany. Therefore, the increased risk premium for French government debt should be expected to persist, even after the election of a mainstream candidate, adding to pressure on the euro project.

Forward guidance - Trump style.

These are strange times in global markets. Trump’s election, previously feared as a universal negative for global markets, has been accompanied by remarkable strength in risk assets. We highlighted investor positioning as a factor last week but now question if there is there more to this rally? Could Trump’s fiscal policies represent a “whatever it takes” moment?

Earnings forecasts: Reassuringly stable?.

Recent trends in consensus earnings forecasts highlight analysts’ confidence in corporate performance for 2016, even as GDP forecasts continue to decline. For now, it appears that the global phenomenon of steadily declining earnings forecasts, a factor behind the relatively weak 2015 equity market performance, has ebbed. There also remains no observable impact on aggregate UK earnings forecasts from Brexit to date, although as we have previously noted for the UK, FX benefits for exporters have offset modest downgrades to sectors focused on the domestic economy.

Was there a “plaza” accord after all?.

Yesterday’s FOMC statement and Yellen’s press comments were unequivocally more dovish than the markets and we were expecting. Going into the meeting there was a reasonable case for preparing the markets for a rate increase in early summer, given declining unemployment and increasing US core CPI. As it turned out, external factors – perhaps a euphemism for undesirable moves in global markets and the US dollar – were in contrast almost overplayed. For us, “Peak fear” was last month’s story, so why bring it up now?

Corporate profits - Too early to call an upturn.

In today’s world of rock star central bankers it can feel like every move in the markets is down to the nuances of monetary policy. Last week’s ECB meeting was a prime example – EUR down on a larger than expected QE package and then minutes later a complete reversal as ever-lower interest rates were downplayed during the press conference.

ECB - Using the bazooka.

With survey data pointing to a marked slowdown in the eurozone manufacturing sector, Exhibit 1; forward inflation expectations at 1.4% significantly lower than at December’s meeting; and a cut in the ECB’s projections for economic growth from 1.7% to 1.4% for 2016, anything other than a forceful response would have been received very poorly by markets. This would in our view also have been tantamount to a policy error. But unlike December, this time markets got what they wished for – an increase in the size and composition of eurozone QE.