A) Is the commodities super cylce over?
Amid the sharp surge in commodity prices over the past ten years, investment into commodities (commodity production and physical/paper commodity holdings) have surged. Now, physical supply is increasing at a faster rate than before. Moreover, amid the subdued commodity price performance of the past two years and improving prospects for equities, investors have started to shift out of cash and commodities into equities (aka "the Great Rotation"). Moroever, Chinese growth has cooled and the Chinese growth mixed has become more dependent on services growth than before and hence less resource intensive. The result is lower demand growth. The effect for the net-commodity consuming countries (Europe ex Norway, Asia ex Malaysia/Indonesia, US) constitute a positive supply shock, i.e. a reduction in inflation and a support for real growth. On the other side, commodity producers should see slower growth.
B) US economy to move back on a self-sustainable growth path
The longer-term outlook for the US economy has become increasingly more favourable. The structural rise in the output of oil & gas, the sharp reduction in household debt service ratios, the improvement in bank balance sheets, the restoration of the monetary transmission mechanism, the recovery in the housing market, an increasing level of pent up demand (business investment & household durable goods) combined with a slow recovery in the employment market and a slow rise in real earnings render the medium-to-long-term growth outlook very favourable. As growth improves, the fiscal deficit will fall markedly further. Moreover, amid the rise in oil & gas output, the current account deficit can decrease slightly further. The current spring soft patch - caused by fiscal tightening and still wrong seasonal adjustments - will be over soon. Inflation does not pose a significant problem. Core inflation rates can move slowly higher again over the medium term. However, as the Fed will likely start to scale back its asset purchases probably in Q4, the pressure on the USD should be for higher levels but commodities should suffer further. Hence, headline inflation rates should remain relatively subdued.
C) Eurozone growth improvement ahead
Eurozone growth expectations have been lowered further. However, the growth outlook is starting to improve. Austerity measures have reduced growth by more than 1% in 2011 and 2012 but should the negative effects should weaken over the next quarters as austerity policies are weakened (Italy) and stretched out over a longer-term time scale (France, Spain, Netherlands). Furthermore, energy prices have reduced growth by 0.5% each year since 2010 but this effect should vanish completely. Spain, Greece, Ireland & Portugal have made substantial progress in restoring their competitiveness. Hence, export growth should increase and the adjustment recessions should weaken. Amid the substantial reduction in bond yields across the Eurozone, monetary accommodation has been increasing and with the usual lags should become more growth supportive. From a more short term perspective, the long and harsh winter has weakened the usual spring upswing in March and up to mid April. But as winter has finally gone, the spring upswing should gather steam. Finally, with the formation of a government in Italy, the uncertainty has been reduced and should help the Italian economy to recover. As a result, the Eurozone growth can improve slowly and start to surprise positively over the next few months vs. the lowered expectations. Inflation risks in the Eurozone remain low as core inflation is being held back by weak credit growth and a very high level of unused capacitiy while easing commodity prices are exerting downward pressure on headline rates as well.
The ECB will likely not cut rates any further but focus on steps to kick-start an ABS market for SME loans. This would help the banking sector, however, it will be a slow process only.
For the sovereigns, debt sustainability has been increasing amid the sharp reduction in sovereign bond yields and the slow improvement in primary balances. Furthermore, they have been shifting banking sector credit risks back onto banking creditors. Systemic risks remain in the Eurozone remain moderate.
D) Strategic Views & Trades
- The bull market in “safe” bonds (aka Bunds, UST) has ended. On a 6m horizon, Bund yields should trade back to the upper end of the trading range of the past 12 months, more substantial upside in UST yields.
- Previous periods of rising safe yields were driven by additional aggressive central bank easing (QE by the US, LTRO/OMT by the ECB) or expectations of central bank tightening (as at the start of this year where markets priced a significant monetary tightening amid early LTRO pre-payments) the next few months will likely be driven by an improvement in the real growth environment. Real yields should be rising and safe curves should steepen
- The environment for carry products in the Eurozone remains favourable as monetary policy remains supportive, the growth improvement improves debt sustainability and the need to generate carry & roll-down remains strong spreads for higher-yielding semi-cores peripherals can narrow further.
- Short Bunds, short UST, UST-Bund spread wideners, short German and French inflation linkers, Bund and OIS curve steepeners, semi-core Bund spread tighteners, outright longs in peripheral bonds (Italy, Spain, Portugal, Ireland, Greece). Prefer periphery vs. similar yielding financials.
- Asset Allocation: overweight equity (from net-commodity consuming countries & long cyclicals); small overweight in bonds (amid overweight in carry products, but underweight in safe assets); underweight commodities & cash; overweight EUR & USD; underweight JPY & commodity fx