For professional investors Asset Allocation Monthly October 2013 Joost van Leenders, CFA Investment specialist - allocation & strategy joost.vanleenders@bnpparibas.com +31 20 527 5126 Fed delays tapering Bond yields fall, equities struggle Now neutral duration Multi-asse et Real Esta te Fixed Income/ duration* Global Convertible Bonds Commodities MARKET REVIEW Economy Leading indicators have continued to improve globally. In the US and the UK, the PMI manufacturing index now points to strong growth. The eurozonee index moved further into positive territory, with gains in most member states. 60 555 50 45 40 35 30 05 06 07 08 US PMI (index) 09 10 11 12 13 Eurozone UK Source: Bloomberg, BNPP IP The eurozone s Economic Sentiment Index also showed broad-based improvement. In emerging economies, the picture is mixed. The PMI improved in all major countries, but in some other countries, the index is still below 50. This does not point to outright contraction, but more likely to below-trend growth. The outlook has improved. In Japan, the quarterly Tankan
Asset Allocation Monthly October 2013 2 survey had its strongest outcome since the final quarter of 2007. In the US and the eurozone, the economy has had some difficulty following the buoyant leading indicators. Consumption growth was modestly positive in the US in August; retail sales in the eurozone were still lower in July than a year earlier. In the US, the housing market has suffered somewhat from rising mortgage rates, while in the eurozone, industrial production fell by more than expected in July. Emerging market exports generally improved in August. All in all, global growth is improving, albeit slowly and somewhat unevenly. Equity markets Global equities rose by 5.0% in US dollars and by 2.6% in euros. Japanese equities (+5.3%) outperformed European (+4.8%), emerging (+3.8%) and US equities (+0.9%). The first two-thirds of the month were decidedly more positive than the final third. 1600 1500 1400 1300 1200 MSCI World (ex EM) & MSCI EM 1100 1050 1000 1100 850 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 MSCI World (lhs) MSCI EM (rhs) The main event for financial markets was the policy meeting of the US Federal Reserve on 17 and 18 September. Market participants had widely expected the Fed to slow its asset purchases of USD 85 billion a month modestly. This would have been welcome since it would have suggested that the economy was improving. The Fed surprised markets by leaving the pace of asset purchases unchanged, saying it wanted more evidence that the economic recovery could be sustained without quantitative easing. It saw risks from rising bond yields and the political stalemate over the government budget and debt ceiling. The boost to equity markets was short-lived. As markets realised that the Fed had created more uncertainty and lost credibility with its fairly rosy growth outlook, equity markets trended lower in the final third of the month. 950 900 Source: Datastream, BNPP IP Bond markets After having risen for four straight months, US government bond yields fell by 13bp. In Germany, yields fell by 7bp, after having risen by 18bp in August. Japanese yields, already extremely low, fell by 3bp. Yields trended higher in the first part of the month. On 10 September, US yields closed near to 3%, their highest since mid-2011, supported by the improving economy and the prospect of a slower pace of bond purchases by the Fed. The Fed continued to say that it would not hike rates soon, even if it could slowdown asset purchases, which barely held yields below 3%. When the Fed decided to keep its asset purchases unchanged, partly because it feared the negative impact of higher yields on the fragile economy, yields fell significantly. Towards the end of the month, they had sunk to 2.6%. German yields peaked at just above 2% during the month. They benefited less from the Fed decision, but still ended the month roughly 20bp lower at 1.8%. Eurozone corporate bond yields were largely unchanged. In the US, the yield on high-yield bonds fell by 26bp, evenly spread over falling government bond yields and narrowing risk spreads. Risk spreads on emerging market bonds in US dollars fell slightly faster, leading to a 33bp drop in yields. 450 400 350 300 250 Emerging bonds risk spread (EMBI+ index) 200 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 INVESTMENT CLIMATE Source: Bloomberg, BNPP IP If there was any recent event which investors were watching closer than usual, it was the September meeting of the monetary policy committee of the US Federal Reserve. While the Fed had been widely expected to taper its growthstimulating asset purchases, it surprised the markets by not doing so. What are the implications?
Asset Allocation Monthly October 2013 3 Economy too weak to taper Most importantly, the Fed wants to see more clear evidence of a sustained recovery before cutting back its USD 85 billion per month asset purchases. Furthermore, the Fed is concerned that the recent tightening of financial conditions (read: the increase in bond yields) could slow the improvement in the economy and the labour market. It also sees the Congressional battle over the government budget for next year and raising the government debt ceiling as a downside risk for the economy, where employment growth, retail sales and durable goods orders have disappointed lately and higher mortgage rates have affected the housing market. US labour (%) 10 9 8 7 6 5 4 3 90 92 94 96 98 00 02 04 06 08 10 12 Unemployment (lhs) That said, we think the Fed missed an opportunity to start tapering off its support for the economy at a point where this was widely expected. It has lost some credibility. The Fed was dismissive of the unemployment rate as an indicator for monetary policy. Initially, tapering had been due to start this year and end by mid-2014 as the unemployment rate fell to 7%. While the rate has eased to 7.3%, disappointingly, this is because participation has dropped. Now the Fed says unemployment is only one of the indicators it watches. We think the impact on bond yields will be more pronounced than on equities. Bond yields to stay low Participation (rhs) Yields fell sharply right after the Fed meeting and have drifted lower since. If anything became clear it is that the Fed is determined to keep yields low. If it were to start tapering later this year, December now looks most likely, but since this is fully data-dependent, it may lower the unemployment rate threshold beyond which it may start hiking rates. Most on the Fed s policy committee foresee gradual monetary tightening only in 2015 with the fed funds rate at or below 2% by the end 68 67 66 65 64 63 62 61 Source: Datastream, BNPP IP of 2016 when growth, inflation and unemployment are expected to have normalised. And the Fed is not alone in keeping rates low. Japan is in the middle of the largest quantitative easing programme ever and in the eurozone, the ECB has reiterated it will keep rates low since the growth prospects may have brightened, although industrial production has disappointed recently. It might even launch another round of longer-term loans for banks. Meanwhile, inflation is nowhere on the horizon. Eurozone labour costs grew at the slowest pace on record in the second quarter, while emerging market inflation has on average been stable at around 4% for more than a year. The extreme steepness of the yield curve even gives bond investors some extra carry. 1 Eurozone unemployment & compensation 13 12 11 10 9 8 7 00 02 04 06 08 10 12 Labour costs (% yoy, rhs) Limited upside for equities Unemployment (%, lhs) Equity markets initially liked the Fed decision a more expansive Fed should in principle be positive for equities, but uncertainty about the course of monetary policy isn t. Furthermore, US company earnings growth has slowed to virtually zero. The gains in equity prices in recent months have lifted the price/earnings ratio to the point where we think US equities have become overvalued. We prefer European and emerging equities, which are more attractively valued and where earnings growth is improving. The economic outlook in these regions is brightening. With a neutral view on Japanese equities, we are neutral on equities overall. 1 In an upward-sloping yield curve, ten-year yields are higher than nine-year yields. So, if an investor buys a ten-year bond and sells it after a year, he will make a profit as prices move inversely to yields. The steeper the yield curve, the bigger the impact of this rolling. Currently, the carry of German Bunds bonds including roll yield is about 3.8%. 4.0 3.5 3.0 2.5 2.0 1.5 1.0 Source: Datastream, BNPP IP
Asset Allocation Monthly October 2013 4 Asset allocation 2 Multi-asset Real Estate Fixed Income/ duration* Global Convertible Bonds Commodities European large caps European small caps US large caps US small caps Japan Emerging markets Real estate European Real Estate US Real Estate Asian Real Estate KEY Over: : Under: Increase: No change: Decrease: Fixed income Euro Govies Euro Govies AAA Euro Short Dated Corporate bonds (EUR) Collateralised bonds (EUR) Euro Inflation Linked High Yield (EUR) High Yield (USD) Emerging Bonds USD Emerging Bonds Local Ccy Foreign exchange AUD CAD CHF DKK EUR GBP HKD JPY NOK NZD SEK SGD USD EM FX Summary outlook Global growth expectations have been revised down repeatedly in the first half of the year. The economic cycle is definitely not strong, but with global trade stabilising and expectations reset lower we think the outlook is neutral. The normalisation of monetary policy in the US is a clear risk across financial markets (equities, commodities, real estate and fixed income). However, we expect the Federal Reserve to withdraw support slowly and carefully. In particular, increases in short-term interest rates remain years away. This is not 1994 all over again. Europe remains vulnerable amid high debt and a lack of growth. Monetary policy can provide an anesthetic for markets, but the lack of growth is steadily undermining political consensus and democratic legitimacy. The EU crisis has gone from an acute to a chronic problem. With the ECB in the background systemic risk seems contained, but the intrinsic problem of unsustainable debt burdens has not been resolved and will repeatedly flare up again. There will be steady downward pressure on wages and prices until unemployment subsides. 2 The tables reflect net positions versus the benchmark within the MAS strategy model portfolio. Views on a particular asset class should not be seen in isolation but in the context of the overall portfolio. * Duration risk is managed independently of the underlying fixed income allocation using government bond futures.
Asset Allocation Monthly October 2013 5 Unchanged. With the US Federal Reserve deciding not to taper its asset purchases, monetary policy continues to support equities. But this has also created uncertainty. The unresolved debate about the 2014 budget and the debt ceiling in the US are negative in the short term. The economic outlook is broadly neutral in our view with somewhat stronger growth in the US and the eurozone now discounted. We remain over European and emerging equities given the attractive valuations and improving growth. Falling inflation could induce the ECB to cut policy rates further or issue new longer-term loans to banks. Small-cap equities: Unchanged. As recession in the eurozone abates, the economic cycle is rosier for European small caps. Valuations have become more attractive, but credit conditions are still negative, leaving us neutral. Valuations are negative for US small caps; lower dividend yields make them relatively unattractive when investors are searching for yield. We are neutral on US small caps. Government bonds: duration Changed. We were stopped out of our short duration position in German Bunds immediately following the September ECB policy meeting where president Draghi s comments were not forceful enough to stop yields from rising. We still think expectations for modest growth, low inflation, rock-bottom official interest rates and favourable fiscal developments all point to low yields. US yields fell after the Fed opted to maintain its asset purchases, seeking to keep yields low. With the spread between the fed funds rate and 10-year yields extremely wide, it will take stronger nominal growth to cause the yield curve to steepen further. Investment-grade corporate bonds: Under Unchanged. European investment-grade yields were unchanged. We still think these bonds are overvalued. With rating downgrades still outnumbering upgrades, we remain under versus European equities despite relatively strong company finances and low default rates. High yield bonds Unchanged. Low economic growth is generally positive for these bonds, especially given the low default rates, as well as the impact of downgraded investment-grade companies entering the high-yield sphere. Coupons may look attractive relative to investment-grade and government bonds, but are low from a historical perspective. The risks to growth, especially in Europe and to some extent in the US, have kept us at neutral. Emerging market bonds Over Unchanged. Risk spreads narrowed after the Fed decision. Improving growth indicators also helped push back concerns over an imminent emerging market crisis. We continue to believe in strengths including improving credit ratings and relatively stable inflation. We see less of a risk now of emerging currencies falling further, but we are already exposed through our over in emerging equities. We continue to prefer debt in USD, leaving us with a short euro position. This reflects our view that the euro should depreciate. Convertible bonds: Unchanged. A limited exposure is warranted to gain diversification benefits, but we currently do not see any opportunities justifying an over or under. Due to the limited liquidity, we prefer active positions in corporate bonds or equities.
Asset Allocation Monthly October 2013 6 Real estate securities: Over Unchanged. We are over US real estate. US real estate has suffered from bond yield volatility, but we think that factors such as growing employment, falling vacancy rates and low construction activity are positive. In Europe, vacancy rates and valuations are unattractive, but yields are relatively high. We are neutral on Europe and Asia. Commodities Unchanged. Commodity prices, especially those of oil and gold, have been volatile due to developments in Syria. Oil fell after a USled intervention became less likely. Looking beyond this, we see an asset class which is costly to hold, faces pressures from supplies coming on stream and could be supported by improvements in the outlook for economic growth.
Asset Allocation Monthly October 2013 7 Disclaimer This material is issued and has been prepared by BNP Paribas Asset Management S.A.S. ( BNPP AM )* a member of BNP Paribas Investment Partners (BNPP IP) **. This material is produced for information purposes only and does not constitute: 1. An offer to buy nor a solicitation to sell, nor shall it form the basis of or be relied upon in connection with any contract or commitment whatsoever or 2. Any investment advice. Opinions included in this material constitute the judgment of BNPP AM at the time specified and may be subject to change without notice. BNPP AM is not obliged to update or alter the information or opinions contained within this material. Investors should consult their own legal and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing in the Financial Instrument(s) in order to make an independent determination of the suitability and consequences of an investment therein, if permitted. Please note that different types of investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment may either be suitable, appropriate or profitable for a client or prospective client s investment portfolio. Given the economic and market risks, there can be no assurance that any investment strategy or strategies mentioned herein will achieve its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the Financial Instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The different strategies applied to the Financial Instruments may have a significant effect on the results portrayed in this material. The value of an investment account may decline as well as rise. Investors may not get back the amount they originally invested. The performance data, as applicable, reflected in this material, do not take into account the commissions, costs incurred on the issue and redemption and taxes. * BNPP AM is an investment manager registered with the Autorité des marchés financiers in France under number 96-02, a simplified joint stock company with a capital of 64,931,168 euros with its registered office at 1, boulevard Haussmann 75009 Paris, France, RCS Paris 319 378 832. www.bnpparibas-am.com. ** BNP Paribas Investment Partners is the global brand name of the BNP Paribas group s asset management services. The individual asset management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner. www.bnpparibas-ip.com