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Update June 2017 Quantitative easing reversal on the horizon

Markets focus on Trump for ever-shorter periods

In the US, political tensions flared up again briefly last month. Allegations directed at Trump relating to interference in the investigation into Russian links to his former national security advisor Flynn led to speculation about a possible impeachment. This caused volatility on the financial markets: US equity prices fell, as did bond yields. Any impeachment is still a long way off, however. Investors quickly calmed down again and risk indicators, such as the VIX, reverted to extremely-low levels. The Trump administration also presented its budget for the next year. The plans revealed that everything is geared to reducing the size of the federal government. The intention to cut taxes also remained intact. Yet there was no sound financial underpinning to back it up, raising the question of how far these tax cuts will actually be implemented.

Persisting political events in Europe

In the wake of Emmanuel Macron’s election victory, political uncertainty in Europe was pushed into the background in early May. Yet this respite proved to be of short duration. In the UK, Theresa May’s party may have won the general election but it was certainly not a resounding victory. The Conservatives have lost their majority in the lower house. This will complicate May’s options for getting the required Brexit legislation through parliament. The currency markets reacted instantly to the exit poll with Sterling falling significantly against both the euro and dollar. As has been the pattern in recent months the declines in Sterling have lead to an increase in UK equity values. Gilt yields have remained relatively stable. In Italy, there is a higher chance of an early election in the autumn of 2017 now that Matteo Renzi’s party has proposed new electoral legislation and this is supported by a number of other parties. However, the question remains as to whether the plan will gain enough support in the Senate. Even if it does, early elections are not a given. President Matarella would first need to call early elections, while he attaches a great deal of importance to political stability. Secondly, elections in the autumn of 2017 would cause havoc to the debate on budget plans for 2018. Given the precarious state of government finances and EU demands for budget consolidation, investors will probably monitor the developments closely.

“On balance, we expect the UK economy to grow very little over the next few quarters.”

The end of free money?

In the meantime, the monetary winds are starting to change direction. The US central bank is forging plans to reduce the size of its balance sheet, while the European Central Bank (ECB) is slowly preparing financial markets for a further tapering of its bond-buying programmes. The aim is to prevent the financial markets being hit by a shockwave (as happened to the Fed in May 2013). The ECB will adjust its forward guidance over the next few months. We believe that after the summer the ECB will announce a further scaling back of its bond-buying programmes from 2018 and complete cessation as of the end of 2018. Not only has the risk of deflation abated almost entirely, the negative side-effects are also becoming increasingly visible. Moreover, the supply of bonds deemed eligible by the ECB is also starting to run out.

Rising bond yields

Unconventional monetary policies have caused very low government bond yields over the past few years, triggering a search for yield. The quantitative easing reversal will mean that the reward for credit risk in government bonds may go up again slightly, especially in Italy. Moreover, term premiums on core EU government bonds are likely to rise. In the US, too, we anticipate higher term premiums on government bonds as a result of the Fed reducing the size of its balance sheet. Yet neither the Eurozone nor the US will undergo a massive interest rate shock. It will be more expensive for companies to raise money on the capital market. The ECB and the Fed have made lending so cheap that companies have easily been able to raise financing. As interest rates rise, we will see which parties have borrowed too much money and which can no longer afford to finance themselves at the higher interest rates. Furthermore, the quantitative easing caused investors to buy equities who would not normally do so. This pushed up equity prices. The higher prices were justified by the expectation that earnings would also rise in the long term. This will now have to happen, especially in Europe. If not, a correction will follow.

Kempen Capital Management N.V. (KCM) is licensed as a manager of various investment funds and to provide investment services and is subject to supervision by the Netherlands Authority for the Financial Markets. This information may not be construed as an offer and provides insufficient basis for an investment decision.

The Asset Allocation Desk

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