Monetary policy at the crossroads



Monetary policy at the crossroads

·    Euro area: low inflation, but no risk for deflation
·    Central banks: Fed on the brakes, ECB hits the gas
·    EUR/USD: euro under pressure
·    Earnings potential on equity markets still given
·    EM equity markets close the gap

“Seen from a general perspective, the euro area GDP growth of 0.2 per cent in the first quarter lacked behind our expectations. We therefore revised our forecasts for the total growth of the euro area for 2014 from 1.5 to 1.2 per cent. However, we still see a slight uptick of the economic growth for the second half of the year and expect a peak in 2015 at 2.0 per cent. At this point, we do not see a risk for deflation in the euro area. Still, price reductions in food and energy led to an overall inflation of 0.5 per cent, which is below the core rate of 0.8 per cent. Despite again slightly increasing rates, the average inflation will stay significantly below the price target of the European Central Bank (ECB). This year, we expect the inflation rate of the euro area at 0.8 per cent and for 2015 a moderate increase to 1.3 per cent, which is clearly below the ECB target rate of about 2 per cent, but also far from deflation,” starts Peter Brezinschek, Head of Raiffeisen Research at Raiffeisen Bank International AG (RBI) the presentation of the „Strategy Global Markets“.

On contrary, the price pressure in the US has risen significantly since spring and, as a direct result of the more robust labor market, consumer prices climbed above the 2 per cent mark since May (qoq). Therefore, the analysts of Raiffeisen Research revised their forecast for this year’s US inflation rate from 1.5 per cent to 1.9 per cent.

Central banks: Fed on the brakes, ECB hits the gas

The US Central Bank Fed announced at its meeting in June a further reduction of its bonds purchases by additional USD 10 bn to a monthly amount of USD 35 bn as of July. It further plans to completely stop the bonds purchases until autumn. However, the current levels of key interest rates are still planned to be unchanged until mid-2015. “We still have serious doubts that the Fed can and will wait that long before increasing the key interest rates. The main argument of the monetary authorities, the high unemployment, has for some time now become invalid, as we expect a de facto full employment with an unemployment rate of only 5.7 per cent in the US to set back in by mid-2015. This in combination with an inflation rate of above 2 per cent should be reason enough to increase the key interest rates earlier,” analyses Brezinschek the current developments in the US.

In contrary to the Fed and its planned exit of its ultra-loose monetary policy, the ECB just decided on an entire package of additional measures. In autumn, a purchase program for Asset Backed Securities could follow. The key interest rates have de facto reached the lowest possible limit.
A new cycle of increased key interest rates is expected for the end of 2015, as negative real interest rates will then no longer be adequate, given the expected more robust economy.

EUR/USD: euro under pressure

“Between January and June, the exchange rate EUR/USD fluctuated between 1.349 and 1.393 according to our previous forecast of a sideways movement within a historically rather narrow range of around 1.35. However, for end-2014 we expect an exchange rate EUR/USD of 1.30, as the speculations of an earlier increase of the US key interest rates might intensify and hence put pressure on the euro,” says Brezinschek.

The yield differential between German and US 2-year government bonds continues to be the main determinant of the development of the exchange rate. While yields on 2-year US government bonds have increased to just about 0.5 per cent, thanks to good economic data, yields on their German counterparts actually sank slightly. The euro area government bond market is strongly influenced by monetary policy measures. The penalty rate on surplus liquidity in the banking system and the generous access to central bank funds is fostering strong investment in short-dated government bonds in particular. Given the recent move by the ECB, German 2-year government bonds have essentially no upward pressure, whereas the upward drift should continue in the US.

Earnings potential on equity markets still given

The upward trend, which started for the MSCI World in March 2009, has now come quite a long way in terms of duration and increase in prices (plus 172 per cent on a total return basis). Compared to the historical average (since 1969), there is currently only a mild above-average valuation of the MSCI World of 5 per cent. According to the analysts of Raiffeisen Research, this is mainly due to fundamental factors (earnings growth, dividend income) and only to about one quarter due to increases in valuations. Taking a long-term perspective, average annual nominal returns of 9 per cent were recorded (over 10 years) at the current valuation levels. Hence, the analysts believe that the current cycle is not yet coming to an end, but in contrary is still showing further earnings potential.

“In a very simplified estimation of returns, under consideration of an annual rate of inflation of 2 per cent and an annual discount of 2 percentage points to reflect the overall lower potential economic and earnings growth rates, we still believe that a long-term real return potential of 5 per cent yoy, before levies and taxes, is realistic,” opens Veronika Lammer, Head of Quant Research and Emerging Markets at Raiffeisen Research, her outlook on the development of the equity markets.

“Given the recent further decline in the performance outlook for alternative risk-free fixed-interest investment products, the risk-reward profile for global equities continues to look attractive. This is even more so the case, as we project a recovery in global economic activity in the foreseeable future, and thus the earnings growth of almost 9 per cent assumed by the consensus for this year seems quite plausible for the MSCI World,” continues Lammer.

From a regional perspective, the MCSI USA stands out in a negative light, as its valuation looks high compared both to its own historical track record as well as to its global counterparts.
For this index, the long-term return prospects are much leaner than outlined above, due to the possible reduction in valuations and lower medium-term earnings growth prospects.

Based on this assessment, however, a better performance is indicated for European equities, especially since there is also potential for earnings to catch up. Even more interesting relationships can be found in various Emerging Markets (EM) equity markets such as China. Also the Japanese equity market is priced attractively and should benefit from pension fund inflows.

EM equity markets close the gap

“Emerging markets are starting to improve, as expected, and benefit from a first economic stabilization of China and the hope for structural improvements in India and Brazil. Hence, we saw a solid performance in the past weeks, which we expect to continue,” says Lammer.

In the past weeks the Chinese stock market profited from the economic stabilization of the People’s Republic. The HSCE Index posted a gain of 7.6 per cent since the beginning of May and still features an attractive valuation compared to the developed and other EM (PER: 7.6). At the same time, the projected earnings growth of 4.6 per cent yoy for 2014 is also far lower than in past years. Nevertheless, for the third quarter an ongoing positive performance is expected, although there is the risk of elevated volatility regarding the real estate and financial market.

Equities moderately overweighted

“Our portfolio for the third quarter of 2014 continues to be balanced with a moderate over-weighting of equities. The equity segment is weighted at 53 per cent, the bond segment at 42 per cent, while the remaining 5 per cent are invested in alternative investments such as real estate,” says Lammer. “Within the equity segment, we focus on Europe and Emerging Markets, but also have the US stock market weighted high. Within the bond segment, we suggest to hold more than half of it in secure European and US government bonds and to mix in CEE government bonds, Eurobonds and euro corporate bonds,” ends Lammer.

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Raiffeisen Bank International AG (RBI) regards both Austria, where it is a leading corporate and investment bank, and Central and Eastern Europe (CEE) as its home market. 15 markets of the region are covered by subsidiary banks. Additionally, the Group comprises numerous other financial service providers, for instance in the fields of leasing, asset management and mergers and acquisitions.

RBI is the only Austrian bank with a presence in both the world's financial centres and in Asia, the group's further geographical area of focus.

In total, more than 57,000 employees service 14.5 million customers through nearly 3,000 business outlets, the great majority of which are located in CEE.

RBI is a fully-consolidated subsidiary of Raiffeisen Zentralbank Österreich AG (RZB). RZB indirectly owns around 60.7 per cent of the common stock, the remainder is in free float. RBI's shares are listed on the Vienna Stock Exchange. RZB is the central institution of the Austrian Raiffeisen Banking Group, the country's largest banking group, and serves as the head office of the entire RZB Group, including RBI.

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