The battle against slowing growth takes shape - Dorval's Macro Corner (July 2019)

"Adapting economic knowledge to market realities and breaking free from the tyranny of indices"
François-Xavier Chauchat
Member of the Investment Committee. Macroeconomic framework and asset allocation.
The debate rages about the implications of the recent sharp decline in global long-term interest rates for financial markets. 

The bearish view is that the collapse of bond yields reflects a high level of anxiety about the economy, and that this is incompatible with rising equity prices. Another risk is that bond yields have gone too low too fast, and that a destabilizing bond market correction might soon take place, like those of May 2013 and May 2015. By contrast, the bullish argument is that equity valuation has not yet adapted to the extraordinary low level of bond yields, as many measures of the equity risk premium suggest. Contrary to a urban legend, very low interest rates have indeed failed to inflate equity P/Es. However, they have contributed to a two-tier equity market, pushing investors to pay higher prices for quality growth stocks, to the detriment of value stocks. As usual, financial market developments will be shaped by the balance between economic conditions and monetary policy. With global manufacturing slowing down further, still significant trade tensions, and the US economy showing signs of weakness, the case for slower growth looks compelling for now. In other times, monetary policy makers were happy to see the economy slowing at this mature stage of the cycle, because they feared overheating. This attitude often contributed to end the expansion cycle. Today, by contrast, any lasting growth slowdown is seen by central banks as a major threat because inflation remains too low for comfort. The ECB has thus announced a new round of monetary easing, and the Fed is expected to cut interest rates at the end of July. Some observers think that this policy is risky for future financial stability, but central banks think differently: their biggest fear is the return of deflation risks if the economy slows further. What they target is a soft landing of the economy.

The return of a combative ECB comes at a moment when the general direction of policy making is moving more clearly pro-growth and pro-federalism in Europe, as shown by the nomination of Christine Lagarde (ECB) and Ursula Von Der Leyen (EU Commission). More fiscal spending and the issuance of “project bonds” (for example on green energy) are now in the cards. Even German policy makers increasingly admit that investing when interest rates are negative might not be a bad idea after all. One should avoid getting too excited, but it is fair to say that almost everything happening these days is taking the opposite way of the view of the Euro doomsayers.
Should investors already anticipate the success of policy makers in stabilizing the slowing global economy? After already 18 months of industrial downturn, it is indeed tempting to call the bottom. In this case, returning gradually to cyclical stocks, and reducing the bias towards defensive and growth stocks may make sense. Meanwhile, continued political and cyclical uncertainties, and substantial corporate profit warnings in the global cyclical universe, argue for caution, at least for now. In our international flexible portfolios, we have a close to normal equity weighting, with no strong bias towards growth or value. We are reducing the duration of our bond holdings, but remain well invested in Italian bonds.


Download Dorval’s Macro Corner of July 2019 in PDF version here


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