Thoughts Ahead of the ECB


By this time next week, we will know the outcome of the deliberations of the European Central Bank. The majority of forecasters expect an announcement on their QE programme, with a EUR20 billion or EUR30 billion reduction (from the current EUR60 billion) to the monthly purchase amount seen as likely, and an extension of between 6 and 12 months also likely. Very slowly, the European Central Bank is shuffling towards the exit, hoping that the financial market revellers will not sulk when they realise that the punch bowl is suddenly nearly empty.

Since the start of the current QE programme in 2014, net Government bond issuance in the Euro Area has remained at extremely subdued levels (as seen in chart 1 courtesy of Deutsche Bank) as Germany in particular has actually been running a budget surplus. What is also illustrated in chart 1 is that the current QE programme vastly exceeds the net Government Bond issuance in the Euro Area.

The change in the next 12 months is going to be quite extraordinary. The extra cash (on top of financing Governments) that the ECB is currently injecting into the system is currently about EUR800 billion. Not only is it likely that QE drops to zero in 12 months or so, but we have to expect net Government bond issuance to increase. In Germany, the austere Finance Minister Schauble has gone, and the Angela Merkel’s new coalition partners are likely to demand increased spending.

Frankly, we would not be surprised if a number of Governments relax the purse strings in the not too distant future. And the net change in QE financing (i.e. QE less net Government bond issuance) could be in the region of EUR1 trillion in the next 12 to 18 months.

Chart 1 – EU Government Bond issuance and QE (last 12 months)

We guess the simple question we need to ask ourselves is what impact is this change actually going to have on financial markets. Of course, nobody really knows (including those in positions of authority), but we can make an educated guess, can’t we? Chart 2 below shows the yield on European High Yield bonds. In the last recession, the yield on European high yield bonds approached 25%. Having slashed rates into negative territory, and unleashed massive asset buying including corporate bonds, ECB policies have pushed the yield on high yield bonds down to nearly 2%.

Without such extraordinary monetary support, what should the yield on these bonds be? It’s anyone’s guess, but certainly more than 2%. Furthermore, in the next recession, we suspect that they will again be well into double digit territory (without the help of any new QE programmes). If this thesis is correct, should investors wait for the final drop of QE to enter the system in about 12 months or so? Or, is it prudent to start selling now, especially as there is still a significant buyer of paper in the system, but with a risk that you may look a little foolish if selling now results in missing out on some marginal short term performance. Perhaps investors should also remember that liquidity in these bonds can be almost non-existent in bear markets.

Chart 2 – European HY bond yield and US 10 year Treasury yield

In theory, with the ECB shuffling towards the exit, and Governments looking to loosen the purse strings, we should expect Sovereign yields to be at risk of drifting higher. Perhaps most at risk of an event is Italy. Yes, there may have been some modest progress made of late in the beleaguered banking sector, but Government finances remain stretched. Debt to GDP remains stubbornly above 130% and the budget deficit has stabilised, but remains above 2%. Most interesting of all is that Italy will hold a general election next year.

Chart 3 – Italian and German 10 year yields and their difference

The risk here is that ECB policies have been so successful in suppressing Italian risks that, when QE ends and the Italian Government has to finance their deficit without their help, the private sector investors will demand a higher rate of interest. Given the lack of economic growth since the creation of the Euro, poor demographic trends, high debt levels and still a still hobbled banking sector, Italy simply cannot afford for yields to rise that much.

Moving on to the FX markets, we remain a little surprised by the resilience of the Euro. Chart 4 below shows Euro on both a trade weighted basis and against the US Dollar. Given the desire of Mario Draghi to weaken the exchange rate in 2014, we are pretty sure that he won’t want to see the trade weighted index rise much more from here. His hope will be that the FX market focuses more on interest rates rather than changes in the QE programme.

Furthermore, Europe (or should we say mostly Germany) continues to enjoy a large surplus on both the trade account and the current account, and so there are reasons to be positive on the single currency. On the negative side of the ledger, we have noted above the Italian election as a potential source of future political uncertainty, and with Brexit and Catalonia still in the headlines, we have to expect political rumblings in Europe for some time.

Chart 4 – The Euro trade weighted index and EUR/USD exchange rate

In the short term, we think the hurdle for sustainable Euro gains is quite high. Speculative accounts retain a long position in the Euro despite a loss of momentum in recent weeks. Also, the yield differential remains positive for the Dollar as can be seen in chart 5 and hopes are rising again that tax reform in the US is gaining momentum, which should be positive for the Dollar.

Chart 5 – US and German yield differentials and Eur/USD exchange rate

That said, the current yield premium for US over Germany is approaching record levels again, as can be seen in chart 6. Unless we see a step change in their relative rates of inflation or terms of trade for example, we suspect that the spread between their respective yields will narrow over time, and in theory that should be pretty bullish for the Euro. The question is will the yield difference narrow as a result of German yields rising more (they are currently sat at -0.30%) or US yields falling? This depends upon your view of the timing for the next US recession, which we suspect is not for a couple of quarters at the very least, more likely a year or more away.

Chart 6 – US and German 5 year yields

What should be apparent from the charts above is that market pricing is approaching very stretched levels, both it in corporate bond markets and European Sovereign bond markets. The potential for markets to reprice as central banks globally wind down their QE programmes and raise rate is quite high. Will the repricing start immediately if the ECB does articulate its full intentions for QE next week? Probably not, but given the potential illiquidity in corporate bonds during more adverse market conditions, staying around at this particular party may be the one of the more unpleasant risks that we think will become apparent in the months ahead.

But the big risk in our opinion, which we’ve articulated before, is of central bank policy error, especially if inflation ticks higher and they choose to normalise more quickly than the market pricing suggests. The risk would seem to be highest in the US, with the Fed tightening on both the rates and balance sheet. But in Europe, we have no idea how a policy unwind will affect financial markets or the real economy; which has to be said is performing better than expected, but possibly due to the calm veneer created by negative rates and QE.

If we are wrong, and normalisation proceeds smoothly, what sort of returns can investors expect in the next year or two or three? Well, in bonds, we would suggest that current coupon returns are close to a best case scenario, i.e. close to zero for a good swathe of EU Sovereign debt of short to medium term duration, and at best 2% or so from periphery 10 year bonds. Corporate bonds current coupon in the 1% to 3% range.


As for equities, perhaps the bull market can extend longer than many expect, but the longer term does not augur well. We have often shown work by John Hussman that indicates US equities will likely generate close zero nominal returns over the next 10 to 12 years. Below is a chart courtesy of GMO showing their predicted 7 year real returns across a number of major asset classes. Although these guys have not predicted the extent of recent gains, their methodology has had much greater predictive success than others during the cyclical swings of the last two decades, and so we should not dismiss their work out of hand. If GMO are correct, every developed market asset is destined for negative real returns for buy and hold investors!

The worst case scenario is another devastating bear market, followed by another great bull market, with a net result of no major gains over a period of between 7 and 12 years.

Chart 7 – GMO expected 7 year real returns

We would also just like to share a couple of charts that argue that, although it is widely accepted that we are in one of the most hated bull markets in history, evidence does suggest that investors have begrudgingly bought into it. Hedge funds are now holding a record long net equity exposure.

Chart 8 – Estimated net stock exposure

Individuals are holding a record low exposure to cash, as per Merrill Lynch data.

Chart 9 – Individual investors allocation to cash

And assets invested into bearish strategies are at a record low.

Chart 10 – Assets invested in bearish funds

So although it seem like equities will never go down again, excitement remains high that the pending tax reform will be a significant positive and Trump is bound to nominate a dovish Fed chair, much of this is already discounted. We have in the past talked of price insensitive buyers (Central Banks, companies themselves and ETFs), but it appears that these guys are tapering their purchases now. We think there is a point out there somewhere when remaining buyers are tapped out, and the worry is that financial assets are simply one big correlated momentum trade, and when the tide turns, it could get nasty very quickly. We just wish we knew when that moment was.


Stewart Richardson
RMG Wealth Management


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