Global Macro Strategy
May 19, 2015
Paul Christopher, CFA®, Head of International Strategy & Co-Head of Global Real Asset Strategy
Analysis and outlook for the global economy
- Since late-April, increasing signs of a quickening recovery appear to be changing the psychology of European financial markets.
- We expect further volatility (wide swings higher or lower) in bond yields and currency exchange rates.
What it may mean for investors
- As aggressive monetary stimulus continues amid a perceptibly more durable economic recovery, we think European equity markets are poised to further gains, while the region’s bond yields and currency values should remain volatile. We continue to favor global equities over bonds and foresee further swings higher and lower in the euro’s value.
International Monetary Stimulus and Economic Recovery
Yields on many European government bonds rebounded in the first half of May, following months of declines that took the benchmark German 10-year bund to near zero and other countries’ sovereign yields to below zero. (Negative yields effectively mean that the bond investor pays the issuer to own the bond.) A weak economic recovery and, more recently, the European Central Bank’s (ECB) commitment to purchase a large quantity of debt, pushed yields lower. Since late-April aggressive monetary stimulus and a perceptibly more durable economic recovery appear to favor Eurozone equity markets. However, the combination of monetary stimulus and a mending economy may create swings up and down in the euro and the region’s bond prices.
The Eurozone economic recovery began in mid-2013 but has struggled to maintain momentum. The improvements are still gradual and a new economic contraction is a risk, if the area's falling consumer prices (i.e. deflation) become chronic. To counter the contraction and deflation risks, the ECB in March began buying large quantities of private and public debt in an 18-month program called "quantitative easing" (QE). The program seeks to replace bonds with cash in investor and bank portfolios, in order to encourage bank lending and private-sector spending. QE does not create economic activity directly but tries to build confidence and to incentivize spending through lower interest rates. This process can take some time: the U.S. Federal Reserve tried three separate QE programs between 2008 and 2014, until confidence and the improved jobs market finally produced a recovery that people could see.
Yet confidence does not always improve uniformly, particularly if policy action has a strong impact on sentiment, as in this case. Expectations of Eurozone QE in late-2014 drove both the euro and Eurozone bond yields sharply lower. Now the cheaper euro might be expected to raise the cost of Eurozone imports, and this would raise inflation expectations; indeed the market for inflation-linked securities does indicate a consensus that Eurozone inflation will return to more normal levels nearer two percent annual growth. In turn, these rising inflation expectations will tend to push bond yields higher, and higher rates and hopes of recovery would see the declining euro reverse course and start to rise once again. The overall impact is that QE, injected once an economy is already recovering, can exaggerate volatility (wide swings higher or lower) in bond yields and currency exchange rates.
The potential for currency and bond yield volatility is particularly notable. The ECB has committed to a pace of bond purchases that could be a multiple of the total net new issuance of private and public Eurozone debt this year. ECB data indicate that the volume of QE purchases during the first month of the latest program exceeded the total net long-term bond issuance of the Eurozone for the first three months of 2015. A potentially large quantity of outstanding bonds is still available, but ECB large-scale buying can pressure bond yields lower, even while the economic improvement tends to push yields higher. These conflicting pressures may compete to push yields higher or lower periodically in the coming months. Likewise, since yields influence the euro’s value, an increase in the currency's exchange rate volatility is also likely.
The equity market impact should be more positive but still carries a negative risk. QE adds liquidity to the equity market, and upbeat economic growth and corporate earnings forecasts tend to improve the attractiveness of equities. Therefore, our base case is for continued equity market gains, but a small risk remains that bond investors might overreact and begin to sell bonds faster than the ECB is buying them. In that case, yields could rise by enough to raise business borrowing costs and lead to a reduction in earnings.
Summary and likely market impact
QE by itself does not directly boost economic growth but can provide important assurance that policymakers will continue to make extra cash available until inflation normalizes. When introduced amid an already improving economy, QE can amplify these improvements through sudden bursts in confidence. We continue to favor global equities over bonds and foresee further swings higher and lower in the euro's value against other major currencies.
Paul Christopher is the head of international strategy and the co-head of real asset strategy for Wells Fargo Investment Institute (WFII), an organization that provides global manager research and investment strategy advice to Wells Fargo’s Wealth, Brokerage, and Retirement (WBR) division. WBR is comprised of Wells Fargo Private Bank, Wells Fargo Advisors, Wells Fargo Institutional Retirement, and Abbot Downing businesses, accounting for more than $1.6 trillion* in assets under administration.
Mr. Christopher focuses on the international economic outlook and offers investment advice on currencies and commodities. He is frequently quoted in the national media, including The Wall Street Journal, The New York Times, Forbes, Time, Investor's Business Daily, USA Today, Bloomberg News, ABC News, NBC News, and CNBC.
Prior to joining Wells Fargo, he developed economic strategies to trade in global financial and commodity futures markets for Eclipse Capital Management. In previous positions, Mr. Christopher supplied international economic perspectives for Wells Fargo predecessor A.G. Edwards, and advised institutional clients of Istanbul-based Global Securities on the oil-based economies of the Caucasus and Central Asia. He has consulted with the governments of Hong Kong, Egypt, Russia, Kazakhstan, and the Kyrgyz Republic on monetary policy issues.
*As of Sept. 30, 2014
Investments in fixed-income securities are subject to interest rate and credit risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility.
Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII) WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.
The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.
Brokerage products and services are offered through Wells Fargo Advisors. Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company. First Clearing, LLC. Member SIPC, is a registered broker-dealer and Non-bank affiliate of Wells Fargo & Company.