Gone are the days of the hawkish US and UK central banks versus the dovish European and Japanese central banks. Brexit has broken the deadlock, with the BoE embarking on its fourth round of quantitative easing and cutting interest rates, the ECB stepping up its interventions in new market segments, and the Bank of Japan tempted to ramp up its ETF purchases and real estate investments. The Fed is also sounding dovish, with the market awaiting Jackson Hole on Friday and attempting to gauge the feasibility of a single rate hike in 2016, compared with two expected last December.
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The pace of rate hikes is decisive for portfolio allocation. If macroeconomic data remains robust, a rate hike will encourage a preference for the USD, value strategies (rebound of assets whose value has corrected below fundamentals), banks at the expense of stocks more exposed to economic cycles (e.g., industry), and large and mid-cap stocks. Conversely, a slower rise in rates would favor commodities, and therefore emerging markets and certain asset classes such as credit and equities, which are less likely to withstand a rise in rates. If macroeconomic data becomes less robust, a rise in rates will encourage a preference for defensive stocks, financial products indexed to volatility, and cash. Conversely, a slower rise in rates by the Fed will favor the valuation of sovereign bonds, gold, the US market, and growth stocks with solid financial fundamentals. These four positions also remain a driver for understanding the recent valuations of two markets that had corrected sharply at the beginning of the year: high-yield bonds and emerging markets.
Since the beginning of the year, high-yield bonds have risen by 11% in Europe and 14% in the United States. Leverage ratios, default rates, earnings revisions, and political uncertainty indices, all of which are usually positively correlated with rising high-yield bond yields, do not justify the correction in spreads on the non-investment grade bond segment. Inflation expectations and sovereign rates, which are usually negatively correlated with spreads, have not been so in recent weeks. Yet macroeconomics accounts for more than 70% of the explained variance in market fluctuations. The main reason for this is monetary policy, via (1) the increase in net liquidity and (2) the decline in yields in markets targeted by asset purchase policies. Market participants are questioning the sustainability of such a disconnect between microeconomic fundamentals and high-yield spreads, and the sustainability of monetary policy as an explanatory factor for performance trends. Central bank action may have its limits, and accentuating a treatment that is not working will not make it any more effective. A reversal of the trend could cause spreads to rise sharply.
The positive cash flows into emerging bond markets since the end of June raise questions about the sustainability of the current bull cycle, both for assets denominated in local currency and those denominated in USD. A consensus seems to be emerging on a negative credit impulse in emerging markets, i.e., a slowdown in credit growth. This would have two implications: (1) a slowdown in import volumes in China, leading to a fall in commodity prices and ultimately a slowdown in economies exposed to this risk, (2) a rise in the US 3-month Libor, already observed, which weighs on USD-denominated debt, a significant portion of which has variable interest rates indexed to the Libor. Thailand, Taiwan, and Malaysia would be affected by this risk in Asia, Chile and Brazil in South America, and Turkey in Europe. These six countries have a high proportion of USD-denominated loans as a percentage of GDP and many maturities under one year. Strong macroeconomic data and a dovish Fed supporting a very slow rise in rates would favor continued asset performance in these countries.
