No rabbit out of Draghi’s hat

Early December, the ECB cut the deposit rate by 10 bps to -0.30% and extended the Public Sector Purchase Programme (PSPP) duration until March 2017 versus September 2016 before. Not enough for the markets that reacted negatively, leading to a stronger euro, higher bond yields and lower stock prices. Many analysts expected further stimulus in terms of conventional and unconventional measures (Table 1).

US: first hike in almost 10 years!

In the meantime, the Fed President, Fed’s Chairwoman, Janet Yellen showed her confidence in the robustness of the US growth. She was thus comfortable to hike the Fed Fund rate from 0.25% to 0.50% for the first time since 2006. However, the timing of the rate hike is less important than the pace that will be macro data dependent. We consider that the Fed’s hiking cycle will remain cautious and gradual in 2016. As a result, we prefer to stay benchmark-neutral in terms of US rate sensitivity. In the euro area, our duration turned slightly short on the 10-year segment before Draghi’s speech to protect our portfolios against a less dovish tone than forecasted.

We favour euro non-core vs. euro core

Country wise, we continue to favour non-core countries compared to core countries. Overall, the monetary cycle remains highly supportive: the extension of the QE program adds about EUR 136 bn of government bonds purchases for 2016 bringing net cash flows below EUR -450 bn. From a valuation perspective, core sovereign debt markets are in expensive territory: for instance, 2-year maturity issues from the sovereign core area are yielding in negative territory (around -0.30%). Non-core debts offer more value especially on the long-end of the curves. From a macroeconomic point of view, manufacturing and services PMI surprised to the upside in Italy and Spain last month (for e.g. Spanish PMI Services at 56.7).

Labour data are also improving with unemployment rate in the euro area declining to 10.7%. We however took partially profit on our non-core overweight. In Spain, volatility could increase as outcome of elections is unclear while market liquidity will be poor with general elections set a couple of days before Christmas. We remain prudent on Portugal as political instability would come back to the forefront in 2016. Additionally, we cut our overweight on France to the benefit of Latvia and Belgium given fiscal and valuation prospects.

Long European break-even inflation

Euro inflation is likely to recover gradually in the coming months despite recent downturn on oil. In the short term, base effects related to the oil price decline over the last months of 2014 should push inflation rapidly back towards 1% in the coming months. Yet, moving back towards the 2% ECB target will be much more complicated to reach. As a result, we expect further monetary efforts by the ECB in the medium term. This should support break-even we assess as rather cheap (Chart. 2). Together with a sustained economic improvement, this all bode well for the relative performance of inflation-linked investments.

  

CURRENCY STRATEGY

Back to neutral on US dollar

Macro dynamics in the US continue to be consistent to a rate hiking cycle with robust growth and reduced unemployment. However, the downward trend of the energy prices maintains the inflation perspectives below Fed’s target. As a result, we expect the hiking cycle in 2016 to be gradual with only 3 hikes in 2016. In the meantime, Draghi disappointed for the first time early December leading to a stronger euro. In this context, the potential of further US strength appears now limited and we preferred to cut our overweight on the USD versus the Euro.

Long SEK

The RiksBank (Swedish Central Bank) is cornered into a too high accommodative policy with a repo rate at -0.35% and aggressive quantitative easing program. In relative terms, this stance looks even more overstated since the ECB has “under-delivered” during its last Monthly Policy Committee. We believe that the Central Bank will soon mitigate its easing tone leading to a strengthening of the Swedish Krona.

EM currencies re-establish a depreciation trend

In November, EM currencies re-entered the medium term depreciation trend. The main drivers of performance were the strong US Non-farm payrolls data in November and December and the Fed minutes which confirmed a December lift-off. Currencies of commodity exporting countries suffered the most from the decline in commodities.

Given the negative market sentiment we remain negative overall on EM currencies and re-built the allocation to US Dollar. We are underweight commodity-linked currencies such as MYR and RUB.

We also turned negative on TRY as the currency appears expensive in a deteriorating external funding environment and high sensitivity to short-term portfolio flows. Political risks are also elevated and unlikely to fade completely as illustrated by the border incident with Russia. In Brazil, political risk is also escalating with the launch of impeachment proceedings against President Rousseff. Political paralysis and uncertainty significantly slow down the pace of much needed structural reforms and postpone the economic adjustment. We, therefore, prefer to be cautious on BRL. We remain negative on Asian currencies overall. Most Asian central banks with the exception of Malaysia and the Philippines have space to ease which can exert pressure on currencies. We are under-weight THB, KRW and MYR and entered a CNY underweight as we expect FX regime liberalization and slowing growth to usher further currency weakness. Yet, we favour other Asian currencies such as IDR which benefits from the improvement of investor sentiment and an attractive valuation. On the positive side, we also increased our overweight on the INR after the ruling party's loss of Bihar's provincial election and the PHP by the solid country fundamentals.