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    Low growth! Low interest rates! Low return?

    Tuesday, June 3, 2014

    • US consumers back again.
    • European recovery slow but steady.
    • Federal Reserve and ECB diametrically opposed to each other.

    In recent weeks, the world economy has continued its upward trend. US growth stagnated in the first quarter of 2014 on account of the exceptionally cold winter. However, it's reassuring that the average American is back again after being absent for a number of years cutting back on their debts. We expect growth to continue rising, with figures of 2.3% and 3% for 2014 and 2015, respectively. We also assume that the recovery in the EMU will continue, although growth figures there will be limited to 1.2% and 1.7%. In the quarters ahead, domestic demand in the EMU will take over from net exports as the key driver of growth.

    The switch from an investment-driven to consumption-driven economy, including further liberalisation of the financial markets, continues to slow economic expansion in China. And that's not set to change in the near future either. Overcapacity in China is being reflected in producer prices that have been falling persistently for almost three years now. Depreciating the Chinese renminbi, and thus marking a temporary break from the policy of recent years of gradually appreciating it, will prolong this overcapacity. The Chinese export of deflation is the main cause of the low rate of inflation around the world.

    Inflation in Europe is being put under extra pressure by wage restraint in problem countries, weak bank balance sheets and, in particular, the strength of the euro. The commonplace link between low or negative inflation and shrinking economic activity is incorrect, at least in this economic cycle. However, we expect the ECB to take steps to push inflation back up from the current 0.7% towards its 2% target. Possible measures are a cut in the key rate and a negative deposit rate, a purchase programme for bonds and/or securitised loans and new conditional LTROs.

    We don't expect the ECB to increase rates any earlier than the end of 2016. Money market rates (and the rate on savings accounts) will stay at around 0% for a very long time yet. Long-term rates won't go up by much either, although European rates will partly follow current long-term rates in the US. The future monetary policy of the Federal Reserve (Fed) is diametrically opposed to that of the ECB. We expect an initial rate hike in the US midway through 2015. The extent to which the Fed can keep its promise of not raising its key rate to above 2% before the end of 2016 will depend on how tight the labour market is and the wage inflation linked to that.

    In search of return

    A raid on return is probably the best way to describe events on the bond markets in recent months. Investors snapped up every bond with any bit of a spread to exploit, from corporate paper to peripheral government bonds, pushing the return on these products lower and lower as a result. Since the turn of the year, and against a backdrop of a somewhat hesitant macroeconomy, less convincing company results and lower inflation, this rally expanded to safe-haven government bonds. Yields have now fallen so low that it’s both difficult and easy for investors at the same time. Extremely difficult in that there is virtually no return left to grab and simple in that there are barely any scenarios left in which to make a gain on bonds. If we were to head into a new recession (and we don't expect that), there is probably still some value left in truly safe government paper but the spreads of most other bonds would widen. In the scenario of gradual recovery that we consider most likely, the slightest increase in interest rates would be enough to push returns into the red.

    The only option left for investors is to take flight to bonds of emerging countries, where the storm has died down a little, the men have been sorted from the boys and the markets are regaining interest for their relatively strong economic and financial fundamentals. Not only are investors finding substantially higher yields there, but, in most cases, undervalued currencies, too.

    In the medium term, shares definitely offer the best return outlook, with dividend yields from most companies significantly higher than the rate on government or even corporate bonds. The increase in merger and acquisition activity is proof of the strong profitability of companies and indicates that businesses themselves still find current valuations at least acceptable. Following eight quarters with no growth, corporate earnings in Europe urgently need to start rising again. Small and medium-sized enterprises in particular – who profit more from a recovery in the local and European economy and are less affected by the expensive euro – should find it easiest to make the leap. That's why we are promoting small and mid-caps, Asian shares and the technology sector as being the best options.


    For more information, don't hesitate to contact:

    Koen De Leus, Financial Analyst, Economist & Strategist, KBC Group

    Tel +32 2 429 37 07 – E-mail koen.deleus@kbc.be

    Bernard Keppenne, Chief Economist, CBC Banque

    Tel +32 2 547 15 32 – E-mail bernard.keppenne@cbc.be

    Dirk Thiels, Head of Investment Strategy, KBC Asset Management

    Tel +32 2 429 44 14 – E-Mail dirk.thiels@kbc.be

    David Willems, Strategist, CBC Banque

    Tel +32 2 547 17 14 – E-mail david.willems@cbc.be