Momentum in rates stalling,
global diversification calling!
Peter De Coensel
Member of the Management Board
Degroof Petercam AM, CIO Fixed Income
Can European equities finally outperform?
Guy Lerminiaux
Member of the Management Board
Degroof Petercam AM, CIO Fundamental Equity
2. 1. 2.
2 Paris, 07/12/16
Momentum in rates stalling,
global diversification calling!
Peter De Coensel
Member of the Management Board
Degroof Petercam AM, CIO Fixed Income
Can European equities finally outperform?
Guy Lerminiaux
Member of the Management Board
Degroof Petercam AM, CIO Fundamental Equity
3. Momentum in rates stalling,
global diversification calling!
Peter De Coensel
CIO Fixed Income
4. Paris, 07/12/164
Conclusion
The end of the
Secular Bond Bull ?
Quantitative
Easing
Momentum
in Rates and
impact on
spreads
Global
Diversification
Trump
5. Paris, 07/12/165
Are we experiencing the end
of the 35 year bull market in
bonds at this moment?
6. US 10Y Nominal Rates
6
How does a bull market looks like! (past 35 years)
Source: Bloomberg & Degroof Petercam
Paris, 07/12/16
7. US 10Y Nominal Rates
7 Paris, 07/12/16
Looking at the past 116 years
Source: R. Shiller database & Degroof Petercam
8. US 10Y REAL Rates is main driver
8 Paris, 07/12/16
Controlling inflation only a partial explanation!
Source: FRED, Bloomberg & Degroof Petercam
9. Real rates pressured by SECULAR forces
9 Paris, 07/12/16
Animal spirits were suppressed!
Source: Laubach & Williams (2013), Bloomberg & Degroof Petercam
Great Financial
Crisis
10. Long Term Outlook
10 Paris, 07/12/16
Demographics will continue to push trend growth down
Source: United Nations & Degroof Petercam
11. Momentum in rates stalling,
global diversification calling!
Peter De Coensel
CIO Fixed Income
12. Long Term Outlook
12 Paris, 07/12/16
Will we resolve the productivity puzzle?
Source: John G. Fernald, "A Quarterly, Utilization-Adjusted Series on Total Factor Productivity."
FRBSF Working Paper 2012-19 (updated 2016). & Degroof Petercam
13. Long Term Outlook
13 Paris, 07/12/16
With what we know today - we only can expect a modest and
gradual “lowmalisation” of real rates over next 5-15 years
Source: Secular drivers of the global real interest rate, Lukasz Rachel and Thomas D Smith (Bank of
England) & Degroof Petercam | global real rate is median LT government bond - inflation expectations
15. Paris, 07/12/1615
Conclusion
The end of the
Secular Bond Bull ?
Quantitative
Easing
Momentum
in Rates and
impact on
spreads
Global
Diversification
Trump
17. Fiscal spending to the rescue
17 Paris, 07/12/16
We should encounter limits to the use of debt financed growth
… might increase credit risk over the medium term
Source: IMF & Degroof Petercam
18. Protectionism to the rescue
18 Paris, 07/12/16
Let’s make inflation linked bonds great again ☺
Source: IMF & Degroof Petercam
19. Paris, 07/12/164
Conclusion
The end of the
Secular Bond Bull ?
Quantitative
Easing
Momentum
in Rates and
impact on
spreads
Global
Diversification
Trump
20. Overview QE
20 Paris, 07/12/16
Fed has passed the baton!
Source: Deutsche Bank, Bloomberg & Degroof Petercam
USD bln/Month
21. Overview QE
21 Paris, 07/12/16
ECB will not disappoint on QE during 2017 and act as backstop
to high political uncertainty
QE Extension till September – December 2017
No official net tapering during 2017
Flexibility in execution
Status quo in policy rates (-0.40% & 0.00%) and TLTRO
22. Paris, 07/12/1622
Conclusion
The end of the
Secular Bond Bull ?
Quantitative
Easing
Momentum
in Rates and
impact on
spreads
Global
Diversification
Trump
24. 24
EUR Rates Outlook
Expect steeper curves
Term premiums are distorted by QE design. Anticipate that ECB will introduce more flexibility
in QE design which handles scarcity premium. Better inflation and growth outlook +
international spill-over effects should lead to steeper curves going forward.
Expect higher core rates throughout the year
Economic recovery should continue over 2017. EUR core rates however remain at historical
low levels. Secular outlook remains challenging for euro area but gradual rise towards to a
new low equilibrium level seem most likely path forward.
Expect Inflation linked bonds to perform
Current valuations are cheap and discount a scenario that the ECB will NOT achieve its target
over the next 5-10 years. If real rates remain well anchored and inflation gradually picks
up/surprises to the upside - inflation linked bonds can provide interesting risk-returns
characteristics
Expect temporary spread volatility to present opportunities
Busy political calendar in Europe. Financial market have been spooked by surprise results in
outcome of Brexit and US elections. Spreads will trade in wider ranges but ECB will prevent a
huge tightening of financial conditions.
Paris, 07/12/16
25. EUR Rates Outlook
25 Paris, 07/12/16
While we are not the only ones facing lowflation troubles …
Source: IMF & Degroof Petercam
26. EUR Rates Outlook
26 Paris, 07/12/16
… Inflation is finally surprising to the upside
Source: Citigroup & Degroof Petercam
Inflation surprise indices measure inflation surprises relative to market expectations. A positive reading implies inflation is higher than expected
and a negative reading indicates lower than expected.
27. EUR Rates
27 Paris, 07/12/16
Supply will not be an issue in 2017 (without ECB tapering)
Source: Morgan Stanley, Bloomberg & Degroof Petercam
Estimates assume Fed continues to reinvest maturing debt ; ECB start tapering in 2018 and ends PSPP in May 2018,; BoJ continues to buy
thropughout 2017 and reduces to 60 trillion Yen in 2018
No ECB
Tapering 2018
30. US Rates Outlook
30 Paris, 07/12/16
Fed: “High Pressure Economy” (Yellen, 14-Oct)
Source: BLS & Degroof Petercam
-
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
-
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16
Average Hourly Earnings
Consistent with a slow hiking path with
potential to overshoot inflation target
Signs of US inflation pressure building
via labour market
Any stimulus from Trump will add to
the pressure
Great
Financial
Crisis
31. US Rates Outlook
31 Paris, 07/12/16
Market expects yield curve to flatten … we agree and see value
in the long end
Source: Bloomberg & Degroof Petercam
1 hike = 0.25%, we assume 1 more hike in 2016, we also expect 2
hikes in both 2017 and 2018, expecting 1.50% - 1.75% by 2019
0.5
1
1.5
2
2.5
3
3.5
2Y 3Y 5Y 7Y 10Y 30Y
Expected Future US Curve
Current
1 Yr Forward
3 Yr Forward
Market: 1 hike in
2016, 1-2 hikes in
2017
Market: 2-3 hikes
in 2018-19
32. US Rates Outlook
32 Paris, 07/12/16
Especially like US TIPS. Market expects US yield curve to
flatten but real rates to increase less than nominal rates …
Source: Bloomberg & Degroof Petercam
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 20Y 30Y
Expected Future US Real Curves
Current
1 Yr Forward
3 Yr Forward
Market is pricing more
stability in real rates
Inflation linked bonds more immune to rates moves driven by inflation.
Evidenced by surge in 10 year inflation expectations of 0.60% since July
34. European IG Credit Outlook
34 Paris, 07/12/16
Fundamentals are not in the spread driving seat …
Source: BofAML, Bloombnerg & Degroof Petercam
35. European IG Credit Outlook
35 Paris, 07/12/16
The unabated drop in rates has made IG fragile to
normalization of rates: carry protection near lows
Source: BofAML, Bloombnerg & Degroof Petercam
At the current yield of 1%, an
adverse move of 20bp would
wipe out a year’s carry
36. EU versus US corporate leverage cycle
36 Paris, 07/12/16
Prudent EU versus confident US
Source: Commerzbank & Degroof Petercam
37. EU versus US capital expenditure cycle
37 Paris, 07/12/16
Both EU and US act prudently
Source: Commerzbank & Degroof Petercam
Net leverage for EU corporates has been stable but so has been organic growth
38. 38
EUR & US IG Credit Outlook
Continuous support of CSPP over 2017 by ECB for EU and US IG
We expect in addition to the current € 46bn purchased since launch early June 2016, that
over 2017 an additional € 80 to € 100bn investment grade corporate bonds are taken out of
the market.
Expect IG spreads in EU and US to act as a buffer against upward rates pressure
We are aware of the tight spread buffer in the EU but see the ‘protected’ asset class as a prime
diversifier going into a charged political year for the EU. Given measured allocation to periphery
we see diversification benefits for the defensive long term investor. In the US we select strong IG
issuers with a domestic tilt and with a stable rating outlook.
Positive
Commercial Real Estate
Construction and
Building Materials
Banks
Healthcare (increasing
risks)
Chemicals
Paper, Pulp and
Packaging (HY)
Personal Household
Neutral
Utilities
Oil and Gas
Metals & Mining
Retail
Food & Beverage
UK Banks
Negative
Industrials Goods &
Servivces
IT
Paris, 07/12/16
40. 40
EUR & US HY Credit Outlook
Expect a non-linear path for spreads in 2017, with bouts of high volatility
We expect less momentum driven markets as the continuous spread tightening trend
is challenged by normalizing pressure on core rates. That will unnerve tactical
institutional and retail cash & ETF investors into next year.
Default risk not to rise significantly in Europe over 2017
Main cohort of HY companies are situated in BB rating bucket (65% of BM). The latter
receive refinancing support in second order from ECB CSPP program. With spreads
around 400bp we are covered for an average 5 year cumulative default cycle resulting
in our neutral stance.
US: Default cycle to decline from an awkward 5.6%, 7.5%+ including energy
Trailing twelve months US High Yield defaults rose to 5.6% October 2016 (vs. 2.8% end
2015). Going into 2017, we expect defaults to decline somewhat as weaker
commodity related companies have been weeded out and the environment still
remains issuer friendly for refinancing.
Prefer high to mid credit quality
Moving further and later into the cycle we look for high quality carry: BB rated
companies and lower levered Bs are preferred over CCC. Curve-wise, shorter duration
(< 7 years) carries our preference.
E
U
R
H
Y
EUR
HY
US
HY
Paris, 07/12/16
41. EUR HY Credit Outlook (2017 scenario)
41 Paris, 07/12/16
Spreads expected to widen … from tight base but expect to
be saved by carry
Source: Barclays, Bloomberg & Degroof Petercam
Despite higher underlying rates
and wider spreads, carry
expected to be sufficient to end
the year with a 2.7% return
42. EUR HY Credit Outlook
42 Paris, 07/12/16
Spreads below average but not at historical tights
Source: Barclays, Bloomberg & Degroof Petercam
43. US HY Credit Outlook (2017 scenario)
43 Paris, 07/12/16
Spreads expected to widen … given a higher shareholder
focus and a declining credit quality
Source: Barclays, Bloomberg & Degroof Petercam
Despite higher
underlying rates and
wider spreads, US HY is
expected to return 1.4%
in 2017
44. US HY Credit Outlook
44 Paris, 07/12/16
Spreads half a standard deviation tighter than average
Source: Barclays, Bloomberg & Degroof Petercam
46. Emerging Market Government Bond Outlook
46 Paris, 07/12/16
Valuation, Valuation, Valuation
Source: JP Morgan, Bloomberg & Degroof Petercam
47. Emerging Market Government Bond Outlook
47 Paris, 07/12/16
Emerging markets growth differential turned the corner.
Expect EM markets to continue recovery, backed by relative
political and economic stability
Source: IMF, Bloomberg & Degroof Petercam
48. Emerging Market Government Bond Outlook
48 Paris, 07/12/16
Diversification benefits between main EM FX pairs are
sound as correlations range between 0.3 and 0.6
Source: Bloomberg & Degroof Petercam
49. Emerging Market Government Bond Outlook
49 Paris, 07/12/16
Correlations frontier markets close to non-existent
Source: Bloomberg & Degroof Petercam
50. Paris, 07/12/1650
Conclusion
The end of the
Secular Bond Bull ?
Quantitative
Easing
Momentum
in Rates and
impact on
spreads
Global
Diversification
Trump
51. Long Term Expected Returns
51 Paris, 07/12/16
Looking at the respective index investment horizons!
Source: BofAML, JP Morgan, Barclays, Bloomberg & Degroof Petercam
52. Building Robust Portfolios
52 Paris, 07/12/16
Staying at home!
Source: BofAML, JP Morgan, Barclays, Bloomberg & Degroof Petercam
Expected volatility is modeled via a dynamic GARCH model
Diversification ratio highlights the nr. of independent risk factors (higher is better)
1.94%
Expected
return
3.9%
Expected
volatility
1.22
Diversification
Ratio
0.49
Expected
Risk/Return
6.37
Duration
53. Source: BofAML, JP Morgan, Barclays, Bloomberg & Degroof Petercam
Expected volatility is modeled via a dynamic GARCH model
Diversification ratio highlights the nr. of independent risk factors (higher is better)
Building Robust Portfolios
53 Paris, 07/12/16
Global diversification without FX exposure 2.05%
Expected
return
3.7%
Expected
volatility
1.25
Diversification
Ratio
0.55
Expected
Risk/Return
6.78
Duration
54. Source: BofAML, JP Morgan, Barclays, Bloomberg & Degroof Petercam
Expected volatility is modeled via a dynamic GARCH model
Diversification ratio highlights the nr. of independent risk factors (higher is better)
LT expected returns
54 Paris, 07/12/16
Full global diversification 2.78%
Expected
return
4.4%
Expected
volatility
1.42
Diversification
Ratio
0.63
Expected
Risk/Return
6.71
Duration
55. Paris, 07/12/1655
Conclusion
The end of the
Secular Bond Bull ?
Quantitative
Easing
Momentum
in Rates and
impact on
spreads
Global
Diversification
Trump
56. UW
2017 Recommendations
56 Paris, 07/12/16
OW
N
EUR Rates, US HY
Global Rates, EUR Inflation, EUR HY
EM Local Debt, EUR & USD Credit, Global
Inflation
2017
57. Main Conclusions
57 Paris, 07/12/16
Bond vigilantes woke up given short term upside inflation uncertainty
Steepening pressure given Treasury intent to fund at long end of rate curves and
increased potential for lesser central bank support
Flattening pressure due to negative growth surprise waning
(versus what’s currently priced in)
Secular forces (demographics, growth, saving & investment
preferences) anchor long term real rates
Global fixed income opportunity set should be tapped in order to seek
sound diversification and be less affected by political and company
specific events/volatility
Smart portfolio construction across fixed income sectors and styles
(benchmarked & unconstrained) based on quality security selection
Bond portfolios must be prepared for the unexpected in order to
weather tail risk events during 2017
58. Momentum in rates stalling,
global diversification calling!
Peter De Coensel
CIO Fixed Income
74. 74 Paris, 07/12/16
Current Outlook on Thematic investing
Tax & Litigation wars (Apple, Deutsche Bank): impact on
multinationals vs local midcaps
Low interest rates: threats (insurance under pressure)
and opportunities (M&A, refinancing)
Selective EM exposure: focus on specific countries
(Banco Santander) and categories (Remy Cointreau)
Commodities back to normal cyclicality: cost focus and
capital allocation discipline (Royal Dutch Shell)
Disruption of traditional industries offers opportunities:
Electric vehicles (Umicore, Infineon), Renewable Energy
(Dong), E-Commerce (Zalando)
75. 75 Paris, 07/12/16
Current Outlook on Thematic investing
Overweight selective midcaps with secular growth story
irrespective of macro-environment (Umicore, Amadeus,
Essilor, Cellnex, Teleperformance), “reluctant sellers”
here.
Global travel growth remains a theme via Autogrill,
Airbus, Accor, Ryanair & Amadeus
Be careful on broken business models, especially those
with too much gearing (retailers, power generators)
Potential impact of new reflation policies, avoid
expensive bond proxies
76. Bond proxies = food&bev+hpc + health Care + utilities + telcos +
real estate => underperforming … as BY toppish...?
Bond proxies vs BondYield
Attention for bond proxies!
76 Paris, 07/12/16
77. Bond proxies have been consensual Long … mind the outflows !
Mind the bond proxies...
77 Paris, 07/12/16
79. 79 Paris, 07/12/16
Current Outlook on Thematic investing
Risks: sequence of elections (Italy, US, France &
Germany) over next 12 months, higher volatility but also
market opportunities
New themes: Security/terrorism (Thales), Infrastructure
spending (roads, telecom networks, buildings…), Trump
Brexit: opportunities and risks, pragmatic approach
82. Long term superior performance: Some statistics from the US.
What are the long term arguments to invest in small caps?
82 Paris, 07/12/16
Statistics of us large caps vs us small caps since 1950
Performance small caps (annualised) 13.1%
Performance large caps (annualised) 10.5%
Outperformance (annualised) 2.6%
Wealth effect of holding small vs large caps 4.55x
% of years small caps outperformed 61.0%
% of 10 year rolling periods small caps outperformed large caps 73.0%
# of 10 years rolling periods with a negative absolute performance 0
83. What are the long term arguments to invest in small caps?
83 Paris, 07/12/16
Small caps represent a big part of the European equity market
(in number of stocks)
Investing in large caps = neglecting more than 87% of the European market
Large caps’ market cap is 4X bigger
10X more Large cap funds than small cap ones
European Universe: number of stocks
European Universe: Total market capitalization
Company size
(EUR)
Number of
companies
% of total
100m - 4bn 2,886 87%
> 4bn 420 13%
Company size
Total mkt cap
(bn EUR)
% of total
100m - 4bn 2,088 20%
> 4bn 8,185 80%
84. 1. Valuation
What about small caps after the strong (relative)
performance of the last years?
84 Paris, 07/12/16
18.2x
Hist. Avg; 14.3x
Top Third; 15.4x
Bottom Third; 13.4x
8.0x
10.0x
12.0x
14.0x
16.0x
18.0x
20.0x
22.0x
'90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 2016E
(IBES)
SMidCapsP/E(Yr+1)
Expensive
Cheap
-0.4xHist. Avg; -1.1x
Top Third; -0.3x
Bottom Third; -0.8x
-6.0x
-4.0x
-2.0x
0.0x
2.0x
'90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 2016E
(IBES)
SMidlessLargeP/E(Yr+1)
Expensive
Cheap
Evolution of Price Earnings ratio of European small caps: not cheap anymore
Relative Price Earnings of Europe small vs large caps: Small caps trading at a small discount
85. 2. Earnings
What about small caps after the strong (relative)
performance of the last years?
85 Paris, 07/12/16
Small cap earnings have really grown,while
Large cap earnings have been in recession
… and this explains the outperformance of
European small vs large caps
European small cap earnings are a
call on the direction of the
European economy/business cycle
86. Source: Company data, Datastream, Morgan Stanley Research, 31/10/16
300-400bp
margin
50-150bp
gap
Ebitda/EV yield margin over local 5yr swap rate:
Quest for yield: yield gap still at high levels
86 Paris, 07/12/16
Still sound gap between property yield and cost of debt
87. Property yields vs 10Y interest rates (%)
Who’s afraid of rising interest rates?
87 Paris, 07/12/16
There is effectively no relationship between property yields and nominal interest rates.
Interest rates are at a 30 year low but property yields are broadly in line with their
historic average.
If interest rate’s rise slowly for the good reason: positive for real estate
88. NAV valuation and NAV growth (%) Pan-Europe property sector
Valuation : Discount to NAV and NAV growth
88 Paris, 07/12/16
89. Sector Beta gradually back to historical levels
Correlation with MSCI Europe
89 Paris, 07/12/16
90. 90 Paris, 07/12/16
Strong relative performance mainly a story of better
visibility of earnings
Efficiency of listed real estate vs equities
Indexed 12m trailing EPS for real estate compared to European equities
soruce : Factset, MSCI, Exane BNP Paribas, 09/2016