Markets Weekly podcast - 02 August 2021

Julien Lafargue (JL): Welcome to this new edition of the Market Weekly podcast by Barclays Private Bank. My name is Julien Lafargue. I’m the Chief Market Strategist at Barclays Private Bank and today I’ll be joined by Michel Vernier, Head of Fixed Income Strategy to discuss the European bond market.

But first let’s take a look at last week’s market. Last week’s three key points grabbed our attention. First, the earnings season. Second, the Fed. And third, China. Starting with earnings season, as things stand companies are on track to deliver one of the highest growth rates ever recorded.

In the US, S&P 500 earnings per share are up 90% year over year on the revenue growth of 22%. Although 89% of companies have produced better-than-expected earnings, the surprise factor is still below that of the first quarter, 17% this quarter versus 25% last quarter. This is something that we expected, as after a terrific first-quarter earnings, have been revised higher by analysts and investors have revised up their expectations as well.

We also argued that Q2 numbers, as good as they could be, will not be a sufficient catalyst to drive meaningful upside. And this appears to be the case as, as of today, the S&P 500 has not really moved throughout the earnings season. Still, this earnings season is underpinning an EPS of around $220 for the S&P 500 in 2022. At current levels this would put the index on a forward price to earnings ratio of around 20 times. Still expensive by historical standards but not in the bubble territory in our opinion given where interest rates are.

When we come to the Fed, the result of the FOMC meeting was very much in line with expectations, with the Federal Reserve keeping rates unchanged but hinting at an upcoming tapering of their asset purchases. This has been underway for a few months now and the market seems well prepared for the Fed to start reducing the pace of its bond purchases. The key debate for investors was is this going to happen at or before, or even after, the Jackson Hole Symposium at the end of August.

The FOMC seems to imply that Jackson Hole could be the good forum to announce tapering although the committee might prefer to wait for September and updated forecast on the economic front to finalise their decision. Whatever that may be the market seems aware that tapering is coming before the end of this year and probably starting early next year. The key question remaining is to what pace this tapering will take place.

Investors expect a reduction of between 15 to 30 billion. Again, whatever that number may be, we don’t think this is going to have a meaningful impact on markets as the Fed has done a great job at preparing investors for this upcoming taper.

The final item of the week was China and the crackdown from local authorities on the educational sector in particular, as the Chinese government decided that companies operating in that sector should be run as non-profit and couldn’t appeal to foreign capital. This shows a step up in the Chinese authorities’ involvement in the domestic economy.

Chinese authorities aren’t completely foreign to these kind of actions and looking back at history we can see several instances of restrictions being implemented across various industries, whether it’s alcohol, video games and most recently internet sector.

For us this most recent crackdown has two main impacts. First, it will likely raise the risky-equity premium investors ask when investing in Chinese equities. Second, and probably most importantly, it doesn’t necessarily change our long-term constructive view on the region.

While we acknowledge the fact that because of this most recent crackdown investors’ confidence has been shaken, and that it will take time for Chinese equities to recover from that, we do believe that over time the growth prospects remain very attractive in the region and that valuations are already reflecting this increased uncertainty. As such, we would see this most recent pullback as an attractive entry point bearing in mind that it may take a while for Chinese equities to actually rebound.

Looking ahead, this week is going to be quieter with some companies still reporting Q2 earnings but none of those are expected to completely change the current storyline. The other key element for this week will be on the macro front with PMIs being released in China, and over the weekend the result was quite mixed, and in Europe followed by the ISM in the US.

Finally, at the end of the week the all-important job number will be published for the month of July. This number will be particularly important in the current context as, as the Fed pointed out, inflation is pretty much in check, likely to cool off in the coming months, and the focus of the central bank is squarely on trying to go back to full employment. As such Friday’s payroll numbers could be a key catalyst in the week ahead.

And with that let’s move on to our guest segment of the day. Michel, thank you for joining us. Today we wanted to discuss the European fixed income market and the ECB. All eyes have been on the Fed lately but we’ve heard quite a few news coming from the ECB. Can you remind us what those are?

Michel Vernier (MV): Yes, thank you very much, Julien. Well, there have been some news coming out of the ECB and it’s quite interesting. But overall the story remains bleak for bond investors as a further extended period of low and, to a large extent, negative yields seem to persist.

So what’s the news? So first, the ECB presented its new framework on how the committee will assess inflation and adjust its policy rate accordingly going forward. In many ways the new framework appears to be a copy of the what Fed did already 12 months ago, but there are some differences as well.

So the common feature is that according to the new framework actual inflation can rise moderately above 2%. Previously the goal was close to 2%. Now, here’s the difference to the Fed. Such an overshoot of inflation is only tolerated when the economy is operating at the lower bound, that’s at lower interest rate levels.

The Fed by comparison seems to be more determined and targets higher average inflation overall. The Fed also incorporates employment in its mandate which provides a more aggressive mandate to push inflation up compared to the ECB. So overall the new framework seems to provide the ECB to be more dovish as previously when it would have been satisfied with inflation close to 2%, but still not as aggressive as the Fed.

JL: So back on this ECB inflation framework, what about their current assessment and what is the ECB actually likely to do from here?

MV: So that’s the astonishing bit. During the last ECB meeting, the central bank revealed that it does actually not believe that its own goal will be reached any time soon. So the current rise in inflation is considered to be transitory, so temporary. So after climbing to 1.9% in 2021, the central bank expects inflation to moderate towards 1.5% and that’s even with deposit rates at -0.5%.

So it’s not difficult to see that the deposit rate will stay there for quite some time and as things stand potentially until 2024 and beyond. And let’s keep in mind for the past 15 years or more, the ECB did not manage to hit its inflation target and the ECB has still in mind this big policy error committed in 2011. Back then the central bank hiked way too early and amplified the recession in the EU afterwards.

So even if the latest inflation search proves to be a bit more sticky, the ECB may try to hold rates as long as possible to be 100% sure that they’re not acting too early this time.

JL: And it seems the market is agreeing with that view in the sense that the German 10-year or the French 10-year government bond yields are negative at this point. Can you tell us what’s our outlook for longer dated bond yield in the eurozone?

MV: Yes, of course. I mean the euro rate curve is impacted by two things. First, the inflation outlook and the future ECB interest rate policy has just highlighted inflation, as much as the short rates seem anchored at depressed levels. Secondly, the long end is furthermore, so the long end of the curve, the interest rate curve, is furthermore impacted by supply and demand.

And here comes the ECB in again. The central bank is currently buying long-end bonds to keep the curve artificially low. The whole envelope of the current pandemic emergency bond-buying programme is €1.85 trillion and likely to be used. This programme will end in March. During the period from now until March the ECB might slow down the pace of buying and this could cause some pressure for yields to go up.

But the ECB is much more flexible than the Fed as they can adjust the pace from one month to another. So overall there’s little room for long ends to move up except in a scenario in which we would face a rapid and aggressive recovery surprise globally, leading to a global rise of yields. The most likely scenario in our view however, is that we may only see a small uplift in the long-end yields while phases of volatility should not be ruled out in the eurozone.

JL: So clearly this is not a great environment for investors who are seeking yield. Where do you think those investors should position themselves in the European bond market?

MV: Yes, I mean investors have two main areas to look at. First, it’s duration, so taking on longer dated bonds. But the euro swap curve starts to show positive yields only from seven or eight years, so hardly an attractive option. Secondly, there’s an option to take on credit risk. We prefer taking on credit risk via BBB-rated bonds and BB segment as well.

Now first it’s about mitigating the risk of realising negative yields. With BBB bonds around the five-year maturity this is achievable and we believe this is already a good starting point. The fallen angel risk, so the risk of downgrades to junk bond, is very low and we expect that we will in fact see even more rating upgrades in the coming quarters.

In order to earn a more positive yield we think the BB-rated bond segment is worth a consideration. Yes, spreads, so the yield premium, is low in historical terms after the rally but the risk is also now much more contained today than it was in the past.

First, within the BB segment we haven’t seen any default during the crisis. And secondly, default rates overall in the high yield market are likely to fall to record lows. So, of course, every segment entails its own risk but the real question for investors should I lose money with certainty by staying in cash, or don’t lose money or earn some yield by taking on measured risk, and the longer you wait the deeper these certain losses.

JL: Thank you very much, Michel. So clearly a hard environment to navigate but one that still provides opportunities for investors who are willing to take those risks and probably want to remain nimble and active in managing their European fixed income exposure.

With that let’s conclude this weekly podcast. We’ll speak to you next week. Thank you.