Central banks: from doves to hawks?

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1 Contents Document intended for professional clients Strong and synchronized global growth, with still no marked acceleration in inflation. Tension on long-term rates following tightening rhetoric from several G10 central banks. Trump s reflationary agenda still bogged down in Congress. The Fed is forced to toughen its tone to safeguard its credibility against an overheating equity market and a fixed-income market that flies in the face of its macroeconomic scenario. The elimination of the Fed put is set to have major consequences for risky asset valuations. Ahead of the traditional summer slowdown in market liquidity, we continue to gradually cut back risk in our portfolios, exiting European high yield credit and local currency emerging market debt. We continue to overweight equities in euro area, Japan and emerging Asia. We still underweight US equities. Central banks: from doves to hawks? Raphaël Gallardo Multi-asset strategist Investment and Client Solutions After several months of bond rally, long-term rates for G10 countries are on an uptrend again. The previous phase of yield curve resteepening dates back to Trump s surprise presidential election victory in the US, with the ensuing hopes of massive fiscal stimulus. Disappointment on 1Q growth on the other side of the pond, along with the executive s stalemate in the tough negotiations with Congress ended this downtrend on sovereign bonds. This time, the sell-off on fixed income was not due to an improvement in world growth, which has stabilized at a three-year high, or fresh promises of fiscal generosity, but rather was a result of a slew of menacing comments from central banks (Fed, ECB, Bank of England, Bank of Canada, Swedish Riksbank). Despite different specifics for each of the economies involved, the sound performance from world growth, equity markets on a high and desperately low volatility are shared factors that can explain this change in tone from central banks. In the US, the UK, Sweden and Canada, central bankers have taken on board an economic situation that is coming close to full employment, with a risk of overheating not of inflation, but rather of private debt and asset prices (real estate, equities). The Chair of the New York Federal Reserve clearly expressed the Fed s frustration on flattening of the yield curve since the start of the tightening cycle that kicked off in 2015, which, as it had indicated in a speech in late 2015, would warrant an acceleration in monetary tightening (rate hikes, balance sheet pruning). In Canada, the change in stance seems to be part of a wider strategy to counter the real estate bubble that has emerged in several states, and includes several macroprudential measures i.e. borrower stress tests, tax on foreign investment. In Sweden, a small economy that is highly dependent on external trade, the Riksbank has long favored currency competitiveness at the expense of financial stability, to the extent that it let household debt rise to worrying levels. In the UK, Mark Carney has to deal with an economy that is close to full employment but which will suffer from a political and economic shock from the UK s forthcoming withdrawal from the EU and high imported inflation. In these four countries, the danger is that the normalization in interest rates will come too late to avoid a severe correction in asset prices, with retroactive effects on the economy and the prospects for hitting the inflation target, thereby revealing the conflict between the central banks institutional mandate (inflation, full employment) and financial stability (role played by wealth effects relating to asset valuations in reaching full employment). The ECB is not (yet) faced with this dilemma, but it must steer its communication to deal with another ambiguity arising from the conflict between the risk of overheating in Germany on the one hand, and support for debtridden peripheral economies on the other.

2 Asset allocation: summary of our global outlook Against a backdrop of ongoing strong (above estimated potential of 3.5%) and synchronized (US, Europe, Asia) world growth, central banks in developed countries are expecting a continuation in the sharp decline in unemployment in their economies. Their stance is logically shifting to prepare the markets for gradual monetary tightening. As mentioned in our editorial on page 1, statements from the ECB, the Fed, the Bank of England, the Bank of Canada and the Bank of Sweden in this respect since the end of June triggered a violent reaction from the fixed-income markets. Were the markets overly complacent on central banks wait-and-see policy? Admittedly, disappointments on the increase in inflation in both the US and the euro area as well as Japan still point to a cautious stance, but the central banks are not yet willing to publicly abandon their coveted Philips curve, which holds that wage inflation and unemployment are related, and embark on a cultural revolution that could endanger their much-cherished independence. But beyond this fresh enigma on the inertia of inflation, the markets got worked up about another plausible explanation for the change in rhetoric from the monetary authorities: while the threat of a swift increase in inflation still looks remote, the authorities could be about to intervene in the name of financial stability in order to curb the increase in private debt and the reduction in risk premiums (equities, credit, real estate) to dangerously low levels (asset bubbles). If this is indeed the central banks intention (the ECB is a separate case), the markets must price in the disappearance of the monetary policy put, which is something of a free option that safeguards against an equity price decline, as central banks are poised to come to the rescue of risky assets at the slightest whiff of a problem. Tactical views GLOBAL -- - = + ++ Equities Fixed income Money Market In our previous publications, we already mentioned our concern on the demanding valuations on equities, credit and real estate, particularly in the US, and this situation is further compounded by economic sentiment indicators reflecting considerable investor complacency on risk (high margin debt, implied volatility at a low, retail investor interest in mutual funds invested in illiquid assets). The Fed will be forced to reiterate this threatening message as the flattening yield curve and low inflation breakevens equate to a public denial of its credibility by the bond market, particularly as the FOMC was sufficiently confident in its economic scenario to announce details of its balance sheet normalization strategy. On the equity market, normalization of long-term rates in line with Fed targets (and therefore a term premium that is positive at the least) would lead to a severe valuation derating, particularly on long durations such as on the Nasdaq. To put the finishing touches to this worrying scene, Trump s reflationary agenda is set to remain bogged down in Congress at least until the end of the year (will the President be tempted to refocus his attention on his protectionist pledges instead?) and signs of the US cyclical slowdown that we mentioned last month were borne out in June (credit, default rate). Difficulties in the US were partly exported to the rest of the world via the dollar s weakening against both developed and emerging world currencies. Ahead of the traditional summer slowdown in market liquidity, we have continued our moves to gradually cut back risk in our portfolios. We continue to overweight equities, with an ongoing focus on euro area reflation (Italy, banks, small caps) and growth in Asia (Japan, emerging Asia), but have exited our plays on European high yield corporate credit and local currency emerging debt. Valuations on these two asset classes looked stretched and vulnerable to rate hikes in G10 countries. Liquidity risk is also higher following massive capital inflows into these markets. We remain heavily underweight in duration on sovereign debt in the euro area. We continue to overweight gold and US Treasuries to hedge our equity exposure. Equities -- - = + ++ US Europe Japan Asia ex Jap EM FIXED INCOME Sovereign -- - = + ++ Euro IG Euro HY EM Debt : monthly views : views of the previous month

3 Equities Hawkish rhetoric from central banks reinforces our country plays The robust worldwide growth pace is creating an attractive context for equity markets that are not subject to excess speculation and/or the risk of impromptu monetary tightening. Markets in the euro area, Japan and emerging Asia seem best poised to meet these three criteria. Equity markets: one-month implied volatility As mentioned above, the US equity market seems to be in a precarious situation in our view, with demanding valuations, the prospects of a cyclical slowdown and the risk of the elimination of the Fed policy put. The widespread drop in the dollar since the end of June has enabled Wall Street to salvage the situation somewhat, while sound earnings reports from financials then helped the S&P 500 spruce up. However, these sound showings from banking stocks look set to be short-lived in view of the slowdown in credit, increased provisions for household defaults and low volatility that wipes out trading revenues. It is also worth noting the risk of a move towards high volatility in the event of even a moderate correction in indices (4-5%?). The flattening of volatility surfaces resulting from quantitative easing policies on the bond and equity markets (quest for yield, partial disappearance of MBS convexity hedging) was exacerbated by the increase in certain investment products based on purely quantitative strategies that use volatility as a valuation/stock selection criterion. In the event of a minor volatility shock, many funds would have to sell off the affected assets, which would further intensify the initial volatility shock. Obviously, in the event of a long-lasting shock on US equity volatility, it would be difficult to expect an outperformance from European and Asian markets. With this in mind, we cut back the extent of our long euro vs. North America play last month. Even disregarding the possibility of a volatility shock on Wall Street, US disappointments since the end of June (growth, tax and healthcare reform) dented the greenback, helping Wall Street outperform Japan and the euro area (in local currency). Tactical views Source: CBOE, Bloomberg Equities -- - = + ++ US Europe Japan Asia ex Jap Developed Markets Emerging Markets Asia Europe LatAm : monthly views : views of the previous month In the euro area, we still play curve steepening and the rebound in credit via the banking sector. We also have a buy stance on small caps, which are more exposed to the domestic recovery and to sound credit conditions, and less vulnerable to the rise in the euro. We have reallocated part of our Japanese overexposure to emerging Asia. The Japanese market remains very exposed to changes in the dollar-yen rate, which did not hold up well against the widespread weakening in the dollar, despite the BOJ setting a cap on long-term Japanese rates. We play the robust semi-conductor cycle via exposure to emerging Asia. We are underexposed to Latin America given the risks on metal prices and lofty valuations on the Brazilian market. 3

4 Bonds Flattening in the US, steepening in Europe In view of signs pointing to the end of the cycle in the US, sluggish inflation and the risk of a dramatic correction for Wall Street s demanding valuations, we maintain our position on flattening of the US yield curve. As mentioned above, the Fed is admittedly exasperated by the yield curve s flattening, which reveals the lack of credibility for its monetary normalization scenario in the medium term. It will use its statements to endeavor to resteepen the curve, helped along by the prospects of its forthcoming moves to reduce its balance sheet. But in our view, the increase in long-term rates will only be temporary as a higher cost of capital (for real estate, capex, consumer credit) would only hasten the US economy s plunge into a phase of below-par growth (2% at best). A flatter yield curve does not indicate an imminent recession but it is an indication to the Fed that it must urgently abandon its normalization scenario if it is to avoid a downturn. In this respect, our long position on US fixed income acts as a hedge for our position on global equities. Germany: 10-year rate Tactical views Fixed income Source: Datastream -- - = + ++ In the euro area, comments from members of the ECB board of governors led to some confusion on the markets. After the reference to the possibility of fresh rate cuts was deleted from its press release in early June, Draghi suggested in Sintra that the recent decline in oil would not warrant fresh monetary easing, but conversely that the economic improvement in the euro area justified an adjustment in the ECB s policy in order to maintain the same degree of monetary flexibility. The minutes of the June meeting revealed that the bank had discussed the end to QE, but then left the situation unchanged. We think that the ECB wants to prepare the markets for a forthcoming reduction in its QE program, which is inevitable due to the lack of eligible German securities in the short term. For political reasons, Draghi desperately wants to avoid giving the impression that the ECB is being forced into this tapering move that is planned for 2018 (Northern Europe rejects a meaningful departure of QE country shares away from the ECB s capital key), with Southern Europe still needing this monetary lifeline. Draghi is concerned about a repeat performance of the taper tantrum that shook the markets in May 2013, when the Fed had announced the forthcoming end to its quantitative easing program. This is particularly sensitive as the announcement of tapering in late 2017 could weaken the Italian economy just before the crucial elections in 2Q 2018, at a time when the US economy could move into a phase of slowdown. The markets should gradually bring the Bund towards a range of %, pointing to the end of liquidity distortions. Sovereign Bonds Euro Core Euro Periph UK US Japan Inflation Credit Euro IG US IG High Yield $High Yield EM Debt : monthly views : views of the previous month We have taken profits on our exposure to European high yield and emerging debt in local currency. These asset classes benefited from major inflows since the start of the year and could be hit by major sell-off in the event of a surge in volatility on US rates. Credit quality for European corporates remains better than for their US counterparts, but European credit could be hit by some major contagion in the event of a correction on US high yield (triggered perhaps by fresh oil weakness, as in 2015).

5 Commodities Neutral on oil and industrial metals, still long on gold Industrial metals prices continue to be buoyed in the short term by the perception of robust world growth and a weak dollar. However, marginal industrial metal demand hinges on China. While economic indicators (GDP, imports) remained on a sound trend in 2Q, the trend in the real estate sector is still towards a slowdown (sales and housing starts). The real estate sector is being hit by the slowdown imposed by the authorities via a hike in financing costs (there is a statistically significant relationship between the 10-year swap and inflation in real estate prices six months later). The chart opposite shows the narrow correlation between the second derivative of credit in China and yearly trends in industrial metals prices with an 8-month lag. For such times as Chinese monetary policy remains restrictive, we cannot really expect a sustainable recovery in metals. And monetary authorities are forced to maintain pressure on the interbank market to both curb speculation in the shadow banking system and stem capital outflows (rate differential with US in particular). We maintain our neutral position. Industrial metals and credit cycle in China Source: Datastream Tactical views Commodities -- - = + ++ Gold is suffering from a context of rising real rates and a lack of inflationary pressure in the short term. Furthermore, the metal has not benefited from the widespread dollar weakness against both developed and emerging currencies. However, we maintain our positive stance. The rise in US long-term rates does not look sustainable in our view given the risks hanging over the economy and over risky asset valuations (equities, credit, real estate). Meanwhile, gold offers a haven from growing geopolitical risk in the Middle East, Asia (Korea), and from the risk of a collapse in the world financial and trade order in the medium term. As mentioned previously, in view of the stalemate on reforms in Congress, Trump could be tempted to step up his protectionist agenda, as the Constitution affords him extensive powers in this respect. Trump s America, which seeks to be isolationist and protectionist, could trigger the erosion of the dollar s reserve currency status all by itself: it is already severely dented by the swift deterioration in the US s external position (-45% of GDP). Several recent initiatives suggest that China is looking into an alternative for the dollar as a transaction currency for its international trade: the chosen candidate is apparently to be an off-shore renminbi that is freely convertible into gold. Chinese banks fragility means that the new currency must be convertible into gold so that it can be accepted as a reserve outside China. The emergence of this new system, even if it is in its early stages, points to a revaluation for gold against the dollar. The oil market continues its rebalancing moves, but doubts remain on whether OPEC can maintain collective discipline (Ecuador stepped down from the agreement, Iraq is cheating, Nigeria and Libya are swiftly increasing production) and whether the agreement is sustainable beyond 1Q 2018 (competition from the Permian basin will still remain). Meanwhile, the High-Yield market can easily finance the development of new US shale oil wells. While the drop in futures prices points to a drop in rigs in operation out to 4Q, the extent of drilled but non-operated wells (5,132) suggests that US production will continue to increase in The fair value for Brent in our models stands at around $45-50/bbl and this could be pushed down by end 2017 in the event of a drop in US demand (sluggish automotive market), unless a shock on High-Yield credit swiftly compromises production for Texan shale (depletion rate for fields means a high reinvestment rate). Oil Industrial metals Gold : monthly views : views of the previous month 5

6 Quantitative Indicators ECONOMIC SITUATION Poor e Good This continuous indicator, which stands between -1 and +1, allows us to assess the world economic outlook. It is based on the level and/or momentum of a range of macroeconomic data (growth, inflation, valuation, earnings). The higher this indicator, the more we favor risky assets. MARKET TRENDS Downtrend e Uptrend This continuous indicator, which stands between -1 and +1, reflects medium-term momentum on the equity markets relative to the fixed income markets. It is based on moving averages of variable length, defined on the basis of volatility. If the indicator is positive, we prefer risky assets. RISK APPETITE Low e High This continuous indicator, which stands between -1 and +1, shows the extent to which various market players are looking for risk in the short term. It is based on an analysis of the level of risk (measured by volatility) and how it is remunerated by the market (measured by premiums or spreads). The higher this indicator, the more we favor risky assets.

7 FLOW Outflow e Inflow This flow indicator measures the investor sentiment for equities, bonds and money markets, calculated using investor flows (data from EPFR) and volumes. The indicator is continuous and lies between -1 and 1. When the indicator enters into positive territory, we favor risk assets. AGGREGATED INDICATOR Risk OFF e Risk ON Our proprietary aggregated indicator is a measure of the equiweighted average of our 4 signals: Economic Outlook, Market Trend, Risk Tolerance and Flow. The indicator is continuous and lies between -1 and 1. How to interpret this indicator: When the indicator enters into positive territory, we favor risk assets. 7

8 Model Portfolio

9 Contributors Coordination by the multi-asset allocation department: the Investment and Client Solutions division of Natixis Asset Management Franck Nicolas Head of Investment and Client Solutions Raphael Gallardo Multi-asset strategist - Investment and Client Solutions Written on July 20, 2017 Natixis Asset Management Limited liability company - Share capital 50,434, Regulated by AMF under no. GP RCS Paris n Registered Office: 21 quai d Austerlitz Paris Cedex 13 - Tel This document is intended for professional clients only. It may not be used for any purpose other than that for which it was intended and may not be reproduced, disseminated or disclosed to third parties, whether in part or in whole, without prior written consent from Natixis Asset Management. No information contained in this document may be interpreted as being contractual in any way. This document has been produced purely for informational purposes. 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