American consumer confidence climbed as the eurozone’s producer confidence took an upswing. Yet, hard economic figures paint a more modest picture. We are maintaining a neutral position on equities in our mixed portfolios.
Rising confidence figures in the US and eurozone
So-called ‘soft data’ on global economic activity remained strong in March. Particularly, figures for consumer confidence in the US and producer confidence in the eurozone continued to improve. Yet, hard economic data, such as consumer spending and business investment, hardly confirmed any acceleration in economic growth. For example, automobile sales in the US dropped to their lowest point in two years. Business orders for capital goods were still around 5 % below the average level since 2012, despite increases in oil prices and profitability.
Strong drop in European inflation in March
Year-on-year inflation in Europe suddenly dropped from 2.0 % in February to 1.5 % in March, landing below the ECB target. Lower oil prices were chiefly to blame for the drop. Additionally, food prices declined following sharp increases since December. Underlying inflation dropped from 0.9 % to 0.7 %, primarily due to the fact that Easter fell in March last year, as opposed to April this year. Normally prices of holiday packages rise very steeply around Easter.
Uncertainty surrounding ECB’s ongoing monetary measures
The iBoxx Overall Index had a negative return of 0.5 % in March, resulting in a negative 1.0 % for the first quarter. The interest rate on German ten-year government bonds rose by twelve basis points, reaching 0.33 %. The Federal Reserve increased the policy interest rate by twenty-five basis points. There was much discussion over the possibility of the ECB raising interest rates or lowering the amount of bonds being bought up each month. The three-month rate (EONIA) on the futures market rose slightly, while the swap market adjusted for lower expectations of future inflation. In Italy, the interest rate rose relatively strongly due to the strong performance of euro-sceptical political parties in the polls. Bonds from emerging markets performed relatively well. Russia and Brazil are in the process of lowering interest rates, considering their inflation figures while exchange rates allow an opportunity for them to do so, and also that both countries’ economies have somewhat improved.
Eurozone equity markets finally on top
Equity markets stalled in March, following a long rally that started with the American elections last November. The market reacted negatively when Trump withdrew his plans to overhaul the American healthcare policy. The MSCI World Index for equities saw a 0.4 % return in euros, resulting in a 4.9 % return for the first quarter. The eurozone was by far the strongest equity market in March, with an increase of 5.4 %, driven mainly by positive adjustments both for the region’s economic growth as well as profit expectations for listed companies. Additionally, the equity market breathed a sigh of relief following the outcome of the Dutch election. Emerging markets performed relatively well, due in part to the fact that investors took reports from the Fed as a sign of less rapid interest rate hikes. For the second time in the first quarter, an American company made a bid on a Dutch AEX company: following Kraft Heinz’s bid on Unilever, PPG made a bid on Akzo Nobel.
Calm on the currency markets
Currency markets kept calm, with only limited realized volatility and an implicit volatility (judging from currency options) that reached its lowest level in two years. Once again, the Mexican peso and Russian rouble appreciated most strongly.
Less favourable long-term economic outlook
The world economy is heading into a number of quarters of historically average growth, which is relatively positive in comparison with the period since the banking crisis. In the longer term, prospects are less favourable, in our view. Hopes of a stronger economy following Trump’s election will not entirely be fulfilled. There is no expectation of any extra impulse towards consumption at this late stage of the business cycle, partly because consumers are confronted with rising prices. A contribution from increasing investments offers more opportunities. We expect fiscal stimulus to take the place of monetary stimulus policy, but uncertainty about Trump’s effectiveness is growing. Following elections in various eurozone countries, we expect to see budget policy playing a larger role in economic growth. On the regional level, we expect, above all, for commodity-exporting emerging countries to contribute to recovery. Here, there is strong potential for recovery.
What is the level of the ten-year interest rate in a normal scenario?
The ten-year interest rate on Dutch government bonds is currently 0.30 %, which is historically low. How high would the ten-year rate be in a normal scenario? We predict the ten-year rate based on the prediction for the average ‘risk-free’ ECB interest rate in the next ten years and a prediction of the risk premium. For the long term, we expect an ECB interest rate that reflects nominal economic growth. We estimate this to be 3.1 %, based on market predictions and research by major multilateral organisations. If the ECB very evenly raises the policy interest rate to this level over the next ten years, then this component will contribute 1.55 % on average. The risk premium normally amounts to about 0.75 %, but currently it is 0 % due to the strong demand for bonds from the ECB and low confidence in the economy. In a normal interest rate scenario, the ten-year rate is 2.30 % (1.55 % + 0.75 %), according to our calculations.
Remaining underweight on bonds
We remain underweight on bonds, compared to cash, in our mixed portfolios. This is due, above all, to the very low interest rate, which makes the expected return on bonds unattractive to us. Additionally, our bond position is based on our economic outlook. In the quarters ahead, we expect to see inflation continue to rise, and less willingness from the ECB when it comes to economic stimulus. After half a year of good economic news, the risk of disappointment is starting to increase. Also, because equity valuations have continued to rise worldwide, we are taking a neutral position on equities in our mixed portfolios.