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Eurozone, interest rates and the reflation trade

The rate of growth in the single currency region continued to gather steam in the last months of 2016, with the leading indicators and key economic data releases so far this year pointing towards persistence in this trajectory and momentum in growth. It is still too premature to predict the rate of growth and whether this momentum will persist, but what is a safe bet is that the conditions seem to be right for the Eurozone to be on a steady path to recovery.

Inflation seems to be picking up, and boosting prices in the process. But what is positive at this stage is that it doesn’t seem to be stoking consumption, whilst, albeit at a timid pace, wage growth is showing small but minute northward ticks.

And this positive vibe in the economy can be felt, or rather may be partially contributed to the fact that the US is also going through its fair share of positive and robust stream of economic data releases. Let’s face it, the Eurozone is more dependent on the US than the US is dependent on the Eurozone, but still the latter seems to be taking cue from its counterpart across the Atlantic.

Clearly, both economies are at different junctures, but never the less, the tone taken by the ECB of late seems to be resolute to the fact that the withdrawal of liquidity in the market is expected to be the MPC’s main theme over the coming 12-18 months.

Furthermore, the trajectory interest rates have taken over the past 5 months have given the investors a clear glimpse, preview, preamble – call it whatever you want – of how the ‘safest’ of government bonds, such as US Treasuries and German Bunds for example, particularly the longer-dated bonds, could turn out of favour. And more importantly, what implications this has had on investor’s total returns.

We have opined that politics is expected to continue to shape global credit markets in 2017, and we use the word ‘continue’ because it has already played a big role in 2016 to date. Brexit, US presidential elections, upcoming French elections – the works. However, fortunately for investors, the recent political events have had little impact on grossly altering sentiment and causing mayhem.

The global economy and financial markets work in tandem are still pricing in a global economic recovery which seemingly gathered steam in H216. Global data remains robust, inflation encouraging and growth outlooks remain buoyant to say the least. Within this context, equity markets continue to show marked signs of strength, with some indices registering record highs.

We have heard a lot about the reflation effect, which in a nutshell is the result of policies designed to expand output, productivity and reduce deflationary pressures, kind of in a way to revive an economy, and this is well being reflected in the equity market valuations too.

However, despite being significantly higher than their lows, particularly in the US, the safe government bonds have failed so far to really sell off big time and officially mark the end of the 30-year bond rally. This is not to say that there have not yet been any structural changes. Yellen’s hawkishness and talk of multiple rate hikes in 2017 is testament to this.

But perhaps equity markets have been more enthusiastic and over exuberant over this famous reflation trade and bond markets need some more convincing for the time being.

It’s a bit difficult to call the shots at this stage for core solid sovereign bonds, such as US Treasuries and German Bunds as they have been range trading at the higher end of the corridor for quite some time now.

However, I cannot but stress the need to reduce downside risk on those portfolios highly exposed to the longer end of the curve and reduce exposure on those bonds which are sitting on a pretty chunky unrealised. Prudency is the name of the game.

This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. 

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