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Negative Rates, the Japanese Way

The negative interest rate regime in Japan is likely to circumvent banks and target currency and market financing. According to Maxime Alimi, from Axa Investment Management, there are three main implications to this:

The Bank of Japan has room to cut further and is likely to use it;
Significant risks of financial market disruptions and
Financial repression for institutional investors.

In their view, “the BoJ played a role in the recent market correction as it sharpened the market’s pessimistic assessment of central banks’ potency to address sluggish growth and inflation.” Japanese banks have, and will continue to have, only a very small share of their reserves effectively taxed, unlike in Europe, plus “banks are very unlikely to pass on negative rates to their clients either through deposits or loans.”

What is the point, then, of cutting interest rates into negative territory? The team believes that the BoJ is counting on non-bank channels to support the economy and borrowing condition, which include:

Currency: lower policy interest rates still influence money market rates and therefore the relative carry of the yen compared to other currencies.
Sovereign yield curve: lower short-term interest rates spread to longer-term yields via the expectation channel.
Corporate bond yields: financing costs for corporates fall as a consequence of lower JGB yields as well as tighter spreads resulting from the search for yield.
Floating-rate bank loans: a large share of mortgages and corporate bank loans are floating and use interbank market rates as benchmarks.

They also believe that given “deposit interest rates have a floor at zero, largely removing the risk of cash withdrawals, the BoJ has a lot of room to cut interest rates below the current -0.1%. They have effectively made the case that ‘there is no floor.'” As well as that with negative rates, the risk of disruptions and illiquidity is high and that the burden of negative interest rates will be mostly borne by institutional investors, which have to invest in debt securities.

“The BoJ is “fighting a war” against deflation and has repeatedly proven its commitment since early 2013. But this war has to be short in order to be won. This was true with QE, it becomes even more true with negative rates. This will require not only monetary policy to be effective but the other pillars of Abe’s policies to come to fruition soon. Otherwise, not only will the benefits of this ‘shock-and-awe’ strategy fade away, but associated risks will mount. More than ever, the clock is ticking for Abenomics,” he concludes.

Concerns Over Negative Interest Rates Overshadow the RMB at the G20 Shanghai Meeting

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The Shanghai G20 meeting concluded with little to show; though little was expected. In line with other global finance leaders’ meetings, the group recognized that while the world economy continues to expand below trend growth, the situation isn’t dire enough to call for coordinated action.

Going into the meeting, People’s Bank of China (PBOC) Governor Zhou Xiaochuan garnered the most attention given that China was hosting the summit. Questions surfaced about how the central bank would balance foreign exchange rates and much needed reform programs. Unsurprisingly, Governor Zhou reiterated the fact that there was no basis for continued weakening of the yuan and that he would not support exports using competitive devaluation.

Instead, growing acceptance over the use of negative interest rates as a form of monetary policy to spur growth seemed to overshadow China and the RMB. This was best summarized by German Finance Minister Wolfgang Schäuble, who said “the debt-financed growth model has reached its limits,” and central banks accepting negative interest rate policies will become a recurring and important theme. The implications are important. First, from an economic standpoint, negative interest rates are viewed as irrational policies as they counter the idea that the future value of money should be greater than the net preserve value. Second, the functioning of banks wanes as they pass up deposit costs in order to prevent withdrawals.

Like other economies, China will need to navigate around this situation. After markets closed on the Monday following the G20 summit, the PBOC cut the reserve requirement ratio (RRR) by 50bps, a move that was seen as a surprise due to the timing of the decision. Releasing an estimate RMB700bn in the banking system, the PBOC move is viewed as extended loose monetary policies, though the liquidity injection likely offsets some open market operations that are expected to mature later on. This would suggest that the PBOC is focused on its domestic policies, which investors should welcome.

China’s next major meeting will be the annual National People’s Congress (NPC) scheduled for the beginning of March. Central authorities are expected to revise their growth estimates from “around 7%” to a stabilized 6.5% to 7.0% estimate. No large scale stimulus is expected. However, following Zhou’s comments at the G20 meeting, it shouldn’t be a surprise to see the PBOC offset counter cyclical measures as it addresses supply side reform. The NPC meeting will likely provide the market with greater clarity on the thinking of the PBOC, especially since this meeting will not be attended by the other 19 G’s.

Have Central Banks Lost Their Superpowers?

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Ahead of the European Central Bank’s (ECB) meeting on March 10th, Keith Wade, Chief Economist & Strategist at Schroders looks at whether central banks’ powers are waning in their fight against falling inflation.

According to him, ahead of the March ECB meeting, three factors have set the scene for potential further policy easing:

Lower oil prices
Fears over global growth
Lower market based measures of inflation expectations

He mentions that “one may expect similar policy responses of rate cuts or quantitative easing (QE) expansion to not produce vastly different medium term results to what we have seen already, with growth and inflation so far limited in the backdrop of subdued global growth. It is perhaps this thought process that leaves the market questioning what effective policies central banks can enact further.”

Wade says that there is a cchance that we could see, for the first time, a lowering of inflation targets across the globe.

For at least the last decade the general belief within markets is that regardless of the situation, central banks will help limit losses in risk assets by lowering interest rates or introducing QE (also known as the central bank ‘put’ option). This school of thought has been questioned in recent weeks, with further possible policy action available to central banks seemingly limited, at least compared to what was available in the past. “Monetary policy has been kept very loose, yet signs of strong growth and inflation are difficult to see… with lower spot inflation used in setting future wages and prices, thus affecting core inflation. The problem with inflation is the longer it stays low, the more embedded lower long-term inflation expectations become.”

With market-based measures of average inflation in the 6-10 year range falling across many major markets, consumer-based expectations of inflation have also been falling in recent years.

The market had previously nicknamed the ECB President ‘Super’ Mario Draghi after the “shock and awe” asset purchasing programme announced in January 2015. “On March 10th we will find out whether that nickname has been reclaimed after the disappointment of the December meeting,” he concludes.

BNP Paribas Investment Partners Appoints Head of Emerging Market Fixed Income

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BNP Paribas Investment Partners announces the appointment of L. Bryan Carter as Head of Emerging Market Fixed Income. He will be based in London and will report to Dominick DeAlto, Chief Investment Officer of Institutional Fixed Income.

Bryan has 12 years’ experience of emerging market fixed income investment and joins from Acadian Asset Management in Boston, where he was lead portfolio manager for benchmark relative and absolute return fixed income strategies and was a member of the Macro Strategy and Investment Policy committees. He joined Acadian in 2007 to launch the company’s emerging market fixed income strategy. Prior to Acadian, he spent four years as an international economist, first at the United States Treasury Department and then at T Rowe Price Associates. Bryan has a BA in Economics & Spanish from Georgetown University and an MPAdm in International Development from Harvard University.

In this role Bryan will have oversight of the management of all emerging market fixed income portfolios and will be responsible for overall investment strategy, performance and the allocation of the risk budget across multiple sources of alpha within emerging markets. BNP Paribas Investment Partners’ emerging market fixed income team currently consists of eight investment professionals and manages client assets totalling $1.3 billion across a range of mutual funds and segregated client accounts.

Dominick DeAlto, Chief Investment Officer of Institutional Fixed Income at BNP Paribas Investment Partners, comments: “Bryan Carter has considerable experience of evaluating emerging market risks and opportunities, gained within both asset management and central government planning, and we are pleased to welcome him as Head of Emerging Market Fixed Income. BNP Paribas Investment Partners has an extensive network of analytical resources based across the broad emerging markets universe, providing us with access to real-time local information. Bryan will be instrumental in further harnessing these capabilities in order to ensure that we continue to deliver optimum investment performance for our clients.”

Bond Markets: a Macro-Economic Cocktail that Calls for a Selective Approach

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The global economy is struggling to grow, and is likely to do so for some time to come. Investors should adapt to this new reality, just as they are being buffeted by a number of economic crosswinds: a strengthening US dollar with its disruptive impact on emerging economies, the knock-on effect on developed nations, deteriorating US fundamentals sparked by a turn in the credit cycle, but an improving economic outlook for Europe, helped by supportive monetary policy.

Against this background, finding investment opportunities is a delicate exercise. With such uncertainty, I believe it is important to focus on quality and liquidity.

The world, in my view, is facing three major challenges: levels of global debt, demographics and deflation.

Since 2007, global debt has increased by $57tn, outpacing world GPD growth. The rise in debt is particularly noticeable in countries like China where the level of corporate debt has scaled new heights, in particular debt issued by non-financials (energy and construction).

When it comes to demographics, the falling birthrate in developed countries has led to the ageing of the population, notably a drop in the population aged between 24 and 52. This age group is the one that drives consumption and economic growth. In other words, demographics will most likely weigh on economic growth over the next few years.

While we are optimistic about the outlook for government bonds because of these two factors – debt levels and demographics – we think what is most important is the phenomenon of “good deflation”, which comes from disruptive technologies and the way firms such as Google, Uber and Amazon change how to do business.

Slowly but surely, these disruptive technologies are taking pricing power away from companies and putting it into the hands of the consumer. As a result, firms are finding it increasingly hard to increase prices, hence “good deflation”. By contrast, deflation, or disinflation, is a long term trend, and has more to do with global overcapacity. Firms are simply producing too much, helped by quantitative easing which has led to a misallocation of capital.

Another consequence of QE has been an increase in the prices of every asset, particularly when it comes to house prices. Housing is the most important component of inflation, looking at the inflation structure in the US. QE has led to higher prices of houses, and then to higher rents. Without this component, inflation in the US is close to zero and the US Federal Reserve, in our view, should focus on that point.

Additionally, the official US unemployment rate is 4.9%, but it doesn’t take into account the participation rate. Factoring this in the real unemployment rate is closer to 13%. Pressure on wages is not that significant, particularly as the jobs created are mostly low-paid jobs in the services sector, including many part-time positions, while the jobs lost were largely well-paid positions. We think therefore there is slack in the labour market.

The manufacturing PMI in the US is about 48, so below a reading of 50 that signifies the sector is expanding: in other words, this key indicator is suggesting there is more than a 50% probability that the country is heading into recession. Services PMI is still above the 50, but it usually takes the same route as the manufacturing PMI (historically, the manufacturing PMI leads the way.)

We think the US Federal Reserve was mistaken in raising the rate in December, because it increased volatility in emerging markets. Despite recent acknowledgment by Janet Yellen of increased macro weakness both within the US and globally, the path of interest rates in the US remains far from clear.

For all these reasons, we prefer to stay away from US corporate debt.

In addition, we are avoiding emerging credit markets. Emerging debt, particularly emerging corporate debt, has been growing significantly in the last few years. The debt burden has getting heavier as loans were often taken out in US dollars. At the time, servicing the debt was relatively cheap but the strengthening of the US dollar has raised the cost of repayment by quite some margin.

Emerging market dollar reserves are falling, suggesting investors are unwinding one of the biggest carry trade we’ve ever witnessed. Since 2009, between seven and nine trillion have been borrowed in US dollars and invested in emerging assets (Chinese financial markets, Chinese housing market, Brazilian debt). Given the fall of local currencies and recession in emerging countries, the situation seems perilous and we prefer to avoid it, even more so as we think it is only a question of time before Saudi Arabia break its peg with the US dollar and China proceeds with a devaluation of its currency.

As a major player in the commodities market, China’s slowdown has an important impact. Commodity prices are currently low and are likely to stay low for a while. Only gold is likely to hold its own, helped by its reputation as a safe haven asset especially if a currency war breaks out, which we believe is bound to happen sooner or later, and above all, when the Fed starts reversing its monetary policy.

The European economy has started to deleverage, unlike the United States. Europe has good momentum, judging by current PMI levels, and its monetary policy is supportive.

In short, we continue to see opportunities within European credit, investment grade bonds and high yield, although we are adopting a more defensive stance and security selection remains paramount.

Column by Ariel Bezalel, fund manager of the Jupiter Dynamic Bond Fund at Jupiter AM

EFG Asset Management Bolsters US Equity Franchise

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EFG Asset Management (EFGAM) – an international provider of actively-managed investment solutions – announced it has brought the management of its top-performing, award-winning New Capital US Growth Fund in-house.

The strategy underpinning the New Capital US Growth Fund was launched for EFGAM in July 2010; based on the firm’s convictions of multi-year growth across the Atlantic, and has since successfully delivered long-term outperformance for clients.

Core members of the existing investment team have officially joined EFGAM as part of the transition. Citywire A rated, Joel Rubenstein, who has been co-lead on the fund since inception will continue as lead manager, working alongside senior portfolio managers Tim Butler and Mike Clulow, as well as research analyst Chelsea Wilson and client portfolio manager Don Klotter, all of whom have been running the fund since inception. There will be no change to the investment process. The US team will continue to be based in Portland, Oregon, and will remain focused on managing the fund. In addition, they will now have the benefit of working alongside other New Capital portfolio managers and analysts with access to the broader global team of investment professionals.

The New Capital US Growth Fund has proven to be a successful component of the wider New Capital fund range, which comprises seven equity funds, three fixed income funds and one multi-asset fund. The Fund has a 5-star rating by Morningstar and a 5 crown rating from FE Trustnet. Compared to the universe of US large cap growth equity funds (approximately 330 funds), it has consistently performed in the top quartile over 1, 3, 5 year periods and since inception. – Moz Afzal, CIO, EFG Asset Management: “This move reflects the successful growth of our New Capital funds franchise. At the time of the fund’s launch we wanted to ensure we had the best managers to implement our strategic views. The strategy has been very fruitful for us, and we are now in the position to provide clients with the best service possible by incorporating all aspects of the fund’s management under the New Capital umbrella.” – Joel Rubenstein, lead portfolio manager: “We have always worked extremely closely with the EFGAM team. Given the success of the fund we are looking forward to taking the relationship to the next stage. We are confident that by joining a much bigger organization with a larger analyst platform, cross-collaboration will enhance the investment process and ultimately performance for clients.”

Bill Gross: “Keep Bond Maturities Short and Borrow” Cheap

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In his latest monthly outlook, Bill Gross compares the sun’s lifespan and that of capitalism and inmediate needs, “our finance based economic system which like the Sun has provided life and productive growth for a long, long time – is running out of fuel and that its remaining time span is something less than 5 billion years,” he writes on his letter, adding that “our global, credit based economic system appears to be in the process of devolving from a production oriented model to one which recycles finance for the benefit of financiers. Making money on money seems to be the system’s flickering objective. Our global financed-based economy is becoming increasingly dormant, not because people don’t want to work or technology isn’t producing better things, but because finance itself is burning out like our future Sun.”

He mentions that what people should know is that the global economy has been powered by credit. And that with negative interest rates dominating 40% of the Euroland bond market and now migrating to Japan, it is less likely that someone will loan money knowing they will receive less in the future. “Negative investment rates and the expansion of central bank balance sheets via quantitative easing are creating negative effects that I have warned about for several years now.” He adds that governments, pension funds and corporations are suffering because they cannot earn enough on their investment portfolios to cover the promises, and that “the damage extends to all savers; households worldwide that saved/invested money for college, retirement or for medical bills. They have been damaged, and only now are becoming aware of it. Negative interest rates do that”.

In his opinion, “the secret in a negative interest rate world that poses extraordinary duration risk for AAA sovereign bonds is to keep bond maturities short and borrow at those attractive yields in a mildly levered form that provides a yield (and expected return) of 5-6%.”

You can read the full letter here.

March: In Like a Lamb, Out Like a Lion?

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In the old days, they said that when March comes in like a lamb it goes out like a lion. The proverb is rooted in the reality that, in the northern hemisphere at least, this month’s weather tends to be changeable and unpredictable—volatile, as we might say in the investing industry. At this time of year, winter and spring contend with one another like bears and bulls in financial markets. When it comes to the seasons, however, we may suffer the odd gale, but we know the days will lengthen, the air will warm. The markets are not so easy to forecast.

Still, March certainly came in like a lamb. The wintry blast of risk aversion lifted around February 11. Since then, world equities are up more than 8%, the VIX Index has fallen from 28 to less than 17 and the price of oil has stabilized. Emerging markets have joined the rally, suggesting that investors are regaining confidence to take long-term value positions. The correlation between daily moves in the oil price and equity markets that had spiked since December is breaking down. Both things suggest investors are focusing on underlying fundamentals again.

Positive data releases are translating into good news for portfolios. Earnings season was not necessarily great—the Q4 decline in U.S. earnings marked the first time there had been three consecutive quarters of year-on-year declines since 2009—but the soft spots in energy and banking were expected and there were few nasty surprises. Last week’s U.S. manufacturing PMI was healthy, construction spending was up, consumers surprised on the upside, and the latest inflation and unemployment indicators looked favorable. Given the improved U.S. economic outlook, markets are again pricing in higher probabilities of modest Fed rate hikes for 2016.

But let’s not forget the other half of that proverb. Is there a lion out there, waiting in the weeds?

In recent editions of our “CIO Perspectives” my colleagues and I acknowledged some serious fundamental challenges to global growth, but argued that the selling was overdone. Some “overselling” has unwound, but the challenges remain:

The price of oil may have stabilized, but it remains low and the future trend is far from clear.
China is still going through its economic transition and recent data has been soft: Last week saw the People’s Bank of China cut its required reserve ratio to add to short-term stimulus, Moody’s switch its outlook on the sovereign debt to negative, and a series of weak PMIs that hurt confidence.
Europe continues with a similar struggle for positive momentum, with soft manufacturing data from Germany and the U.K. and another dip into deflation coming through last week.

And that brings us to the catalysts that could unleash the lion of March: the ECB meeting on the 10th and the Fed meeting a week later. Once again, there is ample scope for market expectations to be met, exceeded or disappointed, and for disruptive signals to be sent. For all the semblance of “normality” over recent weeks, it will be events like these that continue to drive markets, create volatility and dampen the prospects of a sustained breakout by risk assets—at least until we have much stronger levels of confirmation out of the economic data, the earnings outlook and interest-rate expectations. Winter may not have released its grip just yet.

Standish Mellon Asset Management Names Vincent Reinhart Chief Economist

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Standish Mellon Asset Management Company LLC, the fixed income specialist for BNY Mellon Investment Management, announced that Vincent Reinhart will join the firm as Chief Economist.

Reinhart, who will report to David Leduc, Standish’s Chief Executive Officer and Chief Investment Officer, is a recognized leader in economics and the investment management industry. He will serve as a key resource for Standish’s investment team and support developing the firm’s macro framework which is a key part of Standish’s investment process across all strategies.

“We are delighted to have someone of Vincent’s caliber and expertise to further strengthen our global macroeconomic research platform. He will provide additional scope to our team based investment process and will support our focus on developing innovative fixed income solutions,” said David Leduc.

Reinhart succeeds Tom Higgins who passed away late last year. “2015 was difficult as we said goodbye to a dear friend and remarkable colleague, but we find ourselves fortunate to add Vincent to the team,” continued Leduc.

Prior to joining Standish, Mr. Reinhart held the roles of Chief U.S. Economist and Managing Director at Morgan Stanley and is a visiting scholar at the American Enterprise Institute (AEI). In addition, Reinhart worked at the Federal Reserve for twenty-four years where he was responsible for directing research and analysis of monetary policy strategies and the conduct of policy through open market operations, discount window lending, and reserve requirements. Reinhart received his undergraduate training at Fordham University and has graduate degrees in economics at Columbia University.

“I am excited to be able to join Standish, a firm with an impressive history, strong team and excellent investment capabilities,” stated Reinhart. “I look forward to working with my new colleagues to meet the needs of our clients and to help them navigate ever changing market conditions.”

Convertible Bonds: Quality and Potential

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In 2015, global convertible bond issuance totaled USD 82 billion, a very decent level, although slightly down in comparison to 2014 and 2013. Overall, the past four years have seen a supportive dynamism in the primary activity across the major convertible bond markets, with repeated but also first-time issuers adding to the global convertible bond supply.

While the volume of the primary issuance is an important element of the renewal of our market, selectivity remains the key pillar. Our philosophy leads us to primarily focus on accessing cheap option characteristics and strong bond-floors. This answers to one key objective: capturing the convex potential of the asset class.

This implies to differentiate between the most expensive convertible bonds – for which the convex potential is considerably limited – and those which, in contrast, display strong drivers of convexity: cheap implied volatility, high credit quality, strong upside potential. Thus, in the latter part of 2015, our preference went to the Brenntag and FCT-Iren new issues, rather than to the latest deals from Vodafone and Total, whose pricing terms at issuance appeared relatively less attractive to us. Similarly, in January, while we found strong value in the Safran 0% 2020 new issue, we did not participate in the Technip 0.875% 2021, which displayed, at issuance, a higher implied volatility level for similar credit quality profile.

In the long run, convertible bonds’ convex potential is what has enabled the asset class to deliver enhanced risk-adjusted returns relative to equities. We were glad to see that this attractive feature was equally evidenced in the shorter term. Over 2015 market ups and downs, the Stoxx Europe 50 NR posted a volatility 3 times higher than European convertible bonds (represented by the Thomson Reuters Europe Convertible Index €-hedged) for an equivalent yearly performance.

Column by Nicolas Delrue