UIC remains moderately bullish
Upward trend in yields expected to level off
RoRo meter remains at 4, moderately bullish risk positioning
At its latest regular meeting in March, the Union Investment Committee (UIC) reaffirmed its moderately bullish risk positioning (RoRo meter at level 4). The committee decided to establish an overweight exposure to energy commodities (plus 1 percentage point) and reduced the cash position in equal measure. At the start of the month, the UIC had already scaled back the portfolio’s underweight in industrial metals. In addition, an existing short position in the US dollar (against the euro) was closed as part of an adjustment to the positioning and a short position in the Japanese yen (also against the euro) was established instead. All in all, the model portfolio remains underweighted in fixed-income investments, especially ‘safe havens’, and overweighted in equities. The exposure to the commodity segment is neutral.
The UIC is thus maintaining its constructive outlook. A triple boost from progress in the fight against the pandemic, improvements in the economic outlook and continuing monetary and fiscal stimulus measures should keep the capital markets supported and create conditions that favour risk assets. Pressure resulting from rising yields, on the other hand, should diminish over time. After all, cause and momentum are key factors in the assessment of the cross-asset implications of rising yields. If yields go up in the context of an upturn in economic growth, they indicate a recovery and are therefore good news for risk assets. Of course, they still have an (adverse) impact on valuations, for example on share prices. But they also go hand in hand with supportive effects (e.g. corporate revenue growth). So if yields are rising due to improvements in the economic outlook, as has recently been the case, the overall effect may be dampening for risk assets but is unlikely to trigger a trend reversal.
The UIC therefore believes that the recent build-up of pressure was mainly due to the pace at which yields shot up. Internal analyses conducted by Union Investment suggest that the ‘pain threshold’ for the US equity market is an increase of 40 basis points over a period of 35 trading days. In 2021, this threshold was reached back in mid-February. The heightened volatility and weaker performance of share prices are therefore following the historical pattern.
However, the committee expects that, going forward, the upward trend in yields will level off. Inflation expectations, for example, will probably not continue to rise and will thus become less relevant as a yield driver. The higher yield levels that have been achieved should also attract additional buyers. Last but not least, it seems unlikely that the central banks would simply stand by idly and watch a rapid, uncontrolled rise in yields. Expectations in the bond markets also seem to be shifting towards only moderate yield growth.
Improved economic outlook
The economy remains under the influence of the coronavirus pandemic. Case numbers – and, by extension, the prospects for containment measures being eased – vary significantly across different countries. The progress of vaccination efforts has become a crucial factor in this context. In the US and the UK, a significant proportion of the population has now been vaccinated and steps to ease restrictions, for example in the retail and hospitality sectors, are therefore being discussed in more concrete terms or even implemented. The US economy is furthermore enjoying a boost from the new US$ 1.9 trillion coronavirus support programme that was recently adopted. Against this backdrop, Union Investment’s economists have raised their 2021 growth forecast for the US economy to 5.5 per cent. On the other hand, continental European countries are fighting an uphill battle against mutations of the virus. It seems that in these countries, restrictions are more likely to be tightened again (as announced by Germany for the Easter holidays). As a result, economic growth trajectories are likely to diverge at regional level. Globally, however, the upward momentum in growth remains intact.
Complications in individual countries in the near term should therefore not distort our view of the medium-term picture. Over the course of the spring, the UIC expects a significant further revival of economic activity. Milder weather should lead to a fall in case numbers and make it easier to control the spread of the virus. Moreover, vaccine doses should be available in sufficient quantities from the summer. This should then enable economic sectors that had been shut down or severely restricted up to this point to ramp up their operations again. However, it is important to bear in mind that these forecasts are subject to the crucial proviso that the available vaccines are effective against the virus mutations in circulation.
With regard to inflation, the UIC remains confident that there will be no sustained increase. In the short term, there may be some headline-grabbing spikes in the rate of inflation. But over the medium term, factors keeping inflation at moderate levels will prevail.
Monetary policy: focus on favourable financing conditions
The world’s biggest central banks seem to agree with this assessment. At their latest meetings, both the European Central Bank (ECB) and the Federal Reserve (Fed) reacted to the recent increase in inflation with a decidedly unfazed attitude. The UIC believes that the central banks are looking beyond the near-term upward trend as it is largely being driven by coronavirus-related one-off effects. Countermeasures at monetary policy level are therefore unlikely.
As far as the rise in (real) rates of return is concerned, conditions have started to diverge somewhat east and west of the Atlantic. At its meeting in March, the ECB responded by announcing that it would accelerate its bond purchases. Weekly figures published for the individual purchase programmes are now starting to reflect this response. The ECB argues that affordable financing conditions are a key requirement for the recovery of Europe’s economy. The President of the ECB, Christine Lagarde, described the inflation outlook as the “anchor” and financing conditions as the “compass”. However, the central bank has not yet presented this approach in an operationalised format. As a result, there is currently some uncertainty about what responses can be expected from the ECB.
The Fed has taken a different route. Following the last monetary policy meeting, Fed Chair Jerome Powell emphasised that he regards the prevailing financing conditions as favourable and the current monetary policy approach as appropriate. This implies that, overall, the Fed does not (yet) regard the current yield levels as problematic. The UIC therefore does not anticipate an intervention by the Fed in the Treasury market in the short term. However, Powell again dismissed speculation about plans to reduce the volume of the Fed’s bond purchases (‘tapering’) in the near future. We do not expect the Fed to begin tapering its bond buying until the second quarter of 2022 and we thus anticipate an announcement in this respect towards the end of 2021.
A small rise in interest rates in developed markets and a slightly bigger one in emerging markets
Global key interest rates and implied interest-rate paths
Equity weighting within the asset classes
Bonds: yields continue to rise
The upward trend in yields on safe-haven bonds continued unabated. Since hitting a low of 0.5 per cent in August 2020, yields on ten-year US Treasuries have more than tripled to around 1.7 per cent and the yield curve has steepened even further. Bunds reflected this trend, albeit much more moderately. Since the start of November 2020, yields on ten-year Bunds have picked up from minus 0.65 per cent to minus 0.25 per cent, but have largely been trending sideways in recent weeks. Over the coming months, the committee expects the rise to continue, but at a clearly decelerating pace. Risk premiums in carry segments have recently been holding steady, meaning that – in most cases – the potential for spreads to narrow further is very limited. The UIC believes that a further convergence of yields will primarily take place in the market for eurozone periphery and EM government bonds.
Equities: rotation continues
Despite rising yields, many equity markets climbed in recent weeks to their highest ever level (Europe, US) or to a level not seen in a long time (Japan). Investors’ main favourites were value stocks such as shares in energy companies and banks, which are benefiting from higher oil prices and higher interest rates respectively. By contrast, the rising level of interest rates continues to pose a challenge for growth stocks with a high valuation and they trod water for the most part. However, the slowing pace of the rise in yields should enable them to regain a foothold as the year progresses because the fundamental picture and corporate profits continue to provide support. Asian tech stocks, which until January had been driving shares from emerging markets to record highs, have recently seen a correction due to the global rise in yields and, in particular, the growing debate about more regulation in China. The UIC therefore continues to favour stocks from industrialised countries.
Commodities: expansion of ‘energy vs. industrial metals’ pair trade
Saudi Arabia’s unexpected unilateral extension of the OPEC output curbs at the start of March, combined with the disruptions to production as a result of the cold snap in the US, provided fresh momentum for the price of oil. Discussion about extending/tightening coronavirus lockdown measures in Europe has been a huge setback and is likely to continue taking its toll on the physical market (primarily Brent crude and diesel) in the short term. However, the UIC sees this as an opportunity to make a bigger change to the fundamental assessment of the different commodity segments (energy favoured over industrial metals) and, at the same time, to raise the commodity exposure to a neutral weighting. Looking beyond the short term, after all, the global economic picture points to a significant pick-up in demand for oil. Following the sell-off in the past week, the implicit roll yields in the energy sector have fallen slightly but are still at an attractive level of 4 to 5 per cent. Exchange stock levels of industrial metals have recently risen sharply, and the UIC anticipates excess supply for much of this year. Platinum and palladium remain the preferred precious metals as they are likely to remain in demand due to the automotive market getting back into gear. The correction in the gold market has continued and the liquidation of ETF and futures positions is at an advanced stage.
Currencies: euro still favoured
The jump in yields on US government bonds, the Biden administration’s new fiscal stimulus package, and the significant advances in tackling coronavirus in the US have enabled the US dollar to escape from its downward trend in recent weeks. The UIC still believes that the euro is supported but, for the reasons outlined above, the overweighting of the euro is now funded using the Japanese yen rather than the greenback. Firstly, speculative long investors are more heavily invested in yen than they were during previous upturns. A marginal adjustment to the position should weaken the currency. Secondly, there is barely any correlation between the yen and the Japanese interest-rate market. Any adjustments to yield curve control by the Bank of Japan will therefore have an only insignificant effect. Finally, the Japanese yen is likely to weaken in a benign environment of growth because it is a classic ‘safe haven’ currency.
Convertible bonds: brisk primary market activity
The softening of global equity markets has also led to a downturn in the convertible bond markets in the past few weeks, albeit to a lesser extent. In the US, the main reason for the weakness of the convertible bond market is the high proportion of tech paper. Equity market sensitivity fell to around 56 per cent and therefore remained fairly well balanced. Valuations fell sharply in some cases, but not in Europe or Japan. The significant increase in valuations in Europe is primarily attributable to the small proportion of tech bonds combined with a low level of issuance activity. Other regions, particularly the US, have seen a rise in primary market issues in recent weeks. However, these were not always met with good market take-up owing to the weakness of the market and the large supply of new issues.
Unless otherwise noted, all information and illustrations are as at 23 March 2021.
Positioning adjustment from 30 March 2021
The Union Investment Committee (UIC) has made an adjustment to the positioning of the model portfolio. The picture in the global equity markets remains constructive, with macroeconomic conditions and corporate profits continuing to provide support. Given that the detrimental rise in US yields is likely to lose momentum, the UIC expects the environment for equity investments to remain benign. Following the substantial correction of equities from emerging markets (EMs) in March, which was primarily due to the decline in Asian tech stocks, the committee now believes that EM equities have some catch-up potential compared with equities from industrialised countries. The idiosyncratic risks of recent weeks now seem to be reflected in prices, and profits are rising slightly. The significant markdown on this sub-asset class is another factor currently in its favour. The UIC has therefore increased the weighting of EM equities by 2.5 percentage points at the expense of equities from industrialised countries, which means that the overweighting is now evenly distributed among industrialised countries and emerging markets.