Demands for Bonds Expected to Decline

19 Jul 2017

Central banks are heading for a phase-out of their bond buy-up programmes, which will lead to less demand, lower bond prices, and higher interest rates. As a result, we are underweight in bonds and neutral in equities. The eurozone is the most attractive region for equities, offering the best chances for growth.


Strong confidence in the eurozone; UK disappoints
June produced positive figures on the whole for global economic growth. Specifically, indicators for confidence among consumers and companies in the eurozone continued to improve. This may be due to increased confidence in the French government, as well as further European integration (along with its advantages). Europe is less shaken by debt problems recently, now that Greece has managed to reach new agreements with its creditors. Furthermore, there has been little change to the price of commodities, and no bad news from China. The United Kingdom, however, has been less fortunate lately, in contrast to the relatively favourable developments within the eurozone. In snap elections last month, Prime Minister Theresa May’s Conservative Party lost its majority in Parliament. In addition to this, the British economy is experiencing worrisome developments such as very high inflation and consumers who are borrowing more and saving less to keep up their consumption.

Lower inflation in the US due to sector developments
Inflation remained volatile in June. According to preliminary figures, core inflation in the eurozone rose from 0.9 % in May to 1.1 % in June. Similarly to what occurred around Easter, the general price level seemed to be stoked up by seasonal effects, this time because of the timing of the Pentecost bank holiday. In the United States, inflation fell below expectations for the third month in a row; core inflation dropped from 1.5 % to 1.4 %. Sectoral developments related to telephone charges, medicine prices and rent prices were heavily responsible for this.

Investment categories

Bonds: Sudden interest-rate increase in the last week of June
The return on bonds expressed in EUR amounted to negative 0.5% in June according to the iBoxx Overall Index. As such, the return for the year thus far amounts to negative 0.6 %. The interest rate on German ten-year government bonds rose by 16 basis points with an increase of 21 basis points in the last week. In our opinion, the implicit volatility on the bond markets was low enough that investors only needed a little push for such a strong increase. That came during a week in which Mario Draghi announced in a speech that the inflation figures would only temporarily remain disappointingly low. His counterparts in the UK and, for example, Canada and the US indicated they may tighten their monetary policies. European high-yield corporate bonds produced positive returns. Their American equivalents, however, did not, due to their sensitivity to the falling price of oil.

Equities: Weak month with widely inconsistent sector movements
June was a bad month for equities. The MSCI World Index for equities measured in local currencies dropped by negative 0.1 %, reaching 7.1 % for the year thus far. That made June the first month in 2017 with a negative return. The financial sector, however, saw a positive return of 3.2 % thanks to a well-received initial handling of the banking problems in Italy and, especially, Spain, as well as the favourable outcome of the American stress test, and the rise in the interest rate spread. In contrast, IT equities were among the losers, with average losses of 3.8 %. There was notable price development in the retail sector. The American supermarket chain Kroger issued a profit warning which led to a 20 % drop in the company’s share price in June. At the same time, Amazon made a bid on Whole Foods, which resulted in a price increase of 20 % for shares in the health-food chain store. This was seen as a threat to other retailers and caused their share prices to drop.

Draghi paves the way for strong euro
The euro continued to appreciate in June. Compared to the American dollar, the euro booked an increase of nearly 2 %, thanks in part to the aforementioned speech by ECB President Mario Draghi. The US dollar’s total depreciation against the euro thus reached 8.6 % for the year so far.

Economic forecasts

Consensus predicts growth above the historical average
The consensus prediction is that the world economy will grow until 2019 by 3.7 % on average, which is higher than the historical average. We expect that the surprise effect will remain limited. The American economy’s recovery is taking longer than usual, but it is also weaker. As a result, there is less danger of a recession. We predict higher growth in the eurozone. Here, the recovery phase did not start until 2013, following the European debt crisis. Commodities exporters are responsible for the greatest improvement in the world economy, but the extra momentum they are creating will decrease in the quarters ahead. Inflation turned out to be lower than expected in recent months. That is due to the limited sensitivity of wage growth for decreasing unemployment, as well as temporary factors. Gradually, we expect inflation to slowly rise overall, with inflation in the eurozone possibly reaching the upper limit of the ECB’s 2 % target only sometime in the course of 2019.

Asset allocation

Still too early to get on board with American real-estate equities
As a separate investment category, real estate assumes a position between bonds and equities. Cash flows in real estate are easier to predict than those of equities. In terms of cash flows, real estate is most similar to bonds that protect against inflation. After all, rent prices are often indexed based on inflation. On the other hand, the variability of real-estate prices makes real estate more similar to equities. Since the crisis, prices has risen strongly, but the prices of commercial real estate have dipped slightly in recent months. Listed real estate in the US has been through a difficult time in the last twelve months. In the short term, these real-estate funds often behave more like equities than direct real estate, only showing their real-estate characteristics in the longer term. We use the dividend of real-estate funds compared with the return on corporate bonds and the discount compared with their book value as benchmarks for valuation. At the moment, both of these indicate there is room for price increases. However, we believe it is too soon to get on board, considering the enormous increase in value since 2009, possible further hikes in interest rates, and the initial drop in the direct real-estate market.

Phase-out of buy-up programmes in the making
Even after the rise in bond rates (with the inevitable price reductions), we are maintaining an underweight position on bonds compared to cash in our mixed portfolios. It is becoming increasingly clear that various central banks intend to reduce or phase out their buy-up programmes for bonds. This will result in reduced demand for bonds, lower prices and higher interest rates. We do not expect any further surprises in terms of economic activity. We view the eurozone as the region with the best chances for growth. Worldwide, we are taking a neutral position on equities in our mixed portfolios.