EU summit results: no reason to become outright positive
The summit of eurozone leaders at the end of June was well-received by financial markets. Does this make you more optimistic?
The results had some positive elements. Some are longterm in nature such as the creation of a banking union and an integrated budget and economic policy framework. These issues are controversial though since they imply a loss of sovereignty of the member states. While the ultimate goal is clearer – more integration and looser ties between weak member states and weak banking systems – the view of how to get there is not. The positive market reaction was mainly due to the fact that the eurozone bailout funds will in the future be able to recapitalise banks directly (without piling more debt on weak sovereigns) and will be able to buy government bonds in the secondary market. Finally, funds bailing out the Spanish banking sector will not be senior to existing bondholders. The caveats are that direct recapitalisation of banks from the bailout funds will only happen when a eurozone-wide banking supervision scheme is in place. And the additional recourse to the eurozone bailout funds highlight the limited resources available. ECB bond purchases, which are theoretically unlimited, have so far not been able to lower yields sustainably. We view the summit results and the proeurozone outcome of the Greek elections as having reduced the risks of the eurozone disintegrating.
Is this a reason to change your recommendations on equities?
We remain on the side of caution. Equity markets struggled to climb the wall of worries in June, including poor economic data, Greek elections and the eurozone summit: June’s positive performance was mainly due to the gains made after the summit. One could argue that the growth slowdown was discounted by equity markets during the falls in April and May. The resilience after the weak US ISM-manufacturing index in early July argues in favour of this. However, increasing speculation about further monetary stimulus has been supportive. And while the tail risk of eurozone disintegration has reduced, we see the path ahead as long and bumpy and that the growth and fiscal situation still carries downside risk. We maintain our negative recommendation for developed equities and our neutral recommendation for emerging equities.
Do you see other opportunities to take more risk?
We have upgraded both investment grade and high yield corporate bonds from neutral to positive. In general, the corporate sector is highly profitable and has strong balance sheets. High cash positions and a low willingness to invest or acquire competitors are positive for corporate bondholders. We had a neutral recommendation as we saw the environment as positive in the US and negative in Europe, but with the tail risk of eurozone disintegration lowered for now, the situation in Europe has become more neutral. Granted, the US economy is slowing, but we expect growth to stay positive. Corporate bonds tend to do well relatively in periods of low but positive growth. We do not see strong valuation arguments; we merely expect to benefit from higher yields than on cash or government bonds.
Joost van Leenders
Investment specialist allocation & strategy - BNPP IP