Eurozone stays in the lead

19 Jun 2017

Expectations are currently very high for the eurozone’s economy. Meanwhile, growth in the US and China appears to be slowing down. In our mixed portfolios, we remain underweight in bonds and we are neutral in equities.


US: Little consumer spending, despite strong confidence
The macroeconomic activity figures were less strong in May than in the first months of 2017. There were still some surprises, above all in the eurozone, whose economy grew by 0.6 % compared to the final quarter of 2016. Meanwhile, the American economy grew by only 0.3 %. The difference in growth was primarily related to inventories and is no cause for worry about the American economy. It is, however, remarkable that the high level of consumer confidence in the United States has still not led to strong growth in consumption. Sales of cars and houses have been disappointing for several months. Consumer confidence is closely related to wealth development, which is currently very positive due to higher housing and equity prices. At the moment, however, Americans are saving at relatively consistent and high levels, possibly out of concern for the future.

Eurozone: Steady rise in service prices despite dropping inflation
Inflation in the eurozone has been very volatile in recent months. This is mainly due to varying seasonal effects: the Easter holiday fell in April this year, as opposed to March last year. Recent increases due to higher oil prices are now largely a thing of the past. We are seeing an underlying rise in service prices, now that unemployment in the eurozone is steadily shrinking. Because of the strong euro, import prices are depressing the prices of goods. In the US, inflation fell below expectations for the second month in a row. Underlying inflation there dropped from 2.3 % in January to 1.9 % in April.

Investment categories

Bonds: Lower inflation pushes interest levels lower
The return on bonds in euro was 0.5 % in May, according to the iBoxx Overall Index, with year-to-date returns amounting to negative 0.1 %. The interest rate on German ten-year government bonds dropped by 2 basis points, but the greatest contributors to appreciation in government bonds from the eurozone were Italy and France. In France, Emmanuel Macron was elected president, while Italy is poised for early elections after appearing to have reached an agreement on its election laws. The American interest rate on government bonds dropped by 8 basis points, despite the fact that market participants have been clinging to the expectation that the Federal Reserve will raise the interest rate in June. The spread on corporate bonds decreased. In Brazil, President Temer faced accusations of corruption. The interest rate on ten-year Brazilian government bonds rose by 40 basis points, measured in local currency.

Equities: Fewer mergers and takeovers
May was a good months for equities. The MSCI World Index for equities measured in local currencies rose by 1.5 %, amounting to a year-to-date increase of 8.2 %. Because of the rising euro, worldwide returns (measured in euro) were negative in May (-1.1 %). Interest-sensitive sectors achieved outperformance, with utilities leading the pack. Energy companies, on the other hand, lagged behind. The performance gap with the IT sector for the year so far continued to grow, reaching 27 %. There was little merger and takeover activity. The pressure in the pharmaceutical sector has decreased, while PPG withdrew its bid on AkzoNobel after a ruling from the Enterprise Section of the Amsterdam Court of Appeals.

British pound weakens after call for early elections
The euro rose in comparison to nearly any other currency. The Brazilian real was particularly weak, in light of the accusations against President Temer mentioned above. British Prime Minister Theresa May announced early elections, in hopes of turning an expected major victory for the Conservatives into a stronger Brexit mandate. This sparked uncertainty which resulted in a drop of nearly 4 % for the British pound compared with the euro.

Economic forecasts

Great expectations for the eurozone; China and US appear to slow down
Expectations are highly charged for the eurozone’s economy. Consumer and producer sentiment are strong, and there is plenty of untapped economic potential. Additionally, the ECB will continue its stimulus policy over the next six months, and most government budgets are already set. Germany may loosen its purse strings after its elections in September. Optimism has returned to France following Macron’s electoral victory. The Chinese and American economies are showing signs of an underlying slow-down, which could cause global economic growth this year to fall below the historical average. Up to now, inflation has risen at a disappointing rate, but in countries or sectors where unemployment is low, hourly wages are increasing. We expect underlying inflation to rise very gradually in the quarters ahead. As such, the ECB may not have cause to raise interest rates until the end of next year.

Asset allocation

Investor behaviour increasingly important for short-term interest rate development
To gauge the possible developments in the bonds markets, it is conventional to study inflation and the policy of central banks, above all. However, the demand side of the bond market can also provide information about future interest rate development. In recent years, central banks are becoming increasingly important as buyers of bonds. Research shows that all their buy-up programmes combined have lowered the interest rate as much as one percentage point.

Pension funds and insurers are also important investors on the bond market. They are bound to solvency regulations. This is why they follow a policy of hedging the interest-sensitivity of their liabilities. Whenever the interest rate decreases, these investors tend to buy additional bonds, which amplifies interest rate movement. The same applies for so-called CTA funds with their trend-following investment strategies. The activities of other professional and private investors can easily be observed by studying positions on the futures market, measuring the interest rate sensitivity of fund prices, and the movements (or ‘fund flows’) in investment funds. As such, it is essential to seriously watch for signals from the demand side. Particularly in the short term, they can provide valuable information about market movements.

Remaining underweight in bonds
We maintain an underweight position on bonds compared to cash in our mixed portfolios. This is because, in the first place, the interest rate is very low, which makes the expected return unattractive to us. Despite opposite movement in the last few months, we expect inflation to keep slowly rising in the quarters ahead. Additionally, central banks are increasingly inclined to end or scale back their buy-up programmes. The chances of economic disappointments are now increasing. We view the eurozone as the region with the best chances of growth. Worldwide, we take a neutral position on equities in our mixed portfolios.