Where art thou yield curve slope ?

It seems clear that the low point in sovereign yields was reached during the summer and we are still asking how this turning point should be played. The fact that the low point in interest rates has been reached leads us to expect the start of a favourable period for risky assets.

After all, we can assert without fear of being contradicted that asset allocations since the start of the 1980s have been structured by the steady decline in interest rates (the yield on US Treasuries was 16% in May 1981 versus 1.67% today). This decline in rates has obviously largely benefited the bond sphere as well as all the related sector themes. The latter include mainly long duration sectors, high dividend themes and low volatility strategies (these universes of course overlap).

Overall, this structuring has been favourable to growth themes vs. value. To prove this one has only to superimpose the relative performance of growth styles vs. value on the interest rate yield curve to see that any increase in the curve results in a recovery in the performance of value themes vs. growth themes (and vice versa). By using an empirical approach based on a graphic analysis since 2009 (low point for the equity market), one can associate a level of relative performance (growth vs. value) with a level of yield curve steepness.

The currently observed recovery for value in Europe corresponds to an implicit yield curve level of 80bp (difference between the 10-year Bund and the ECB Main refinancing rate ). This is in line with the yield estimates of Natixis fixed income strategists out to December 2017.

The point we are making is this: the movement observed in value, mainly in financials, at the expense of growth themes, is therefore probably already priced in by the market. Why are we so sure? Because no notable acceleration is as yet perceptible in terms of earnings per share in Europe. Admittedly, Q3 results reports are poised to begin and earnings should benefit from the positive base effects recorded in the energy sector. The rise in oil prices will end the drain that this sector represented (along with banking stocks) on earnings growth for the Stoxx 600. But for 2017, the equation remains complicated. For sure, the rise in inflation to 1.5% (once again mainly attributable to the base effects stemming from oil prices) could give a boost to the nominal component of earnings.

For the moment, the 2017 consensus (IBES) stands at 12.9% with growth of 52.7% for energy… That said, caution is still called for in view of the overly optimistic systematic bias seen over the last six years. Moreover, a notable shift is unlikely with growth by volume set to remain flat in the euro zone at 1.2% (volume) and political risk still very much present (activation of Article 50 by the UK in Q1 17, Italian Referendum, French Presidential Elections).

In a nutshell, while the long-term consequences of a normalisation of monetary policy clearly call for the restoration of value / financial themes, the short-term consequences are not so clear cut. On the one hand, the European macro economy remains soft, the USA will slow slightly next year and emerging countries are the only ones likely to see their growth rate pick up notably (to 4.6% by volume vs. 4.2% this year). And a number of long-duration sectors (Food, Beverages, Cosmetics, Luxury goods, Pharmaceuticals, etc.) are exposed to these zones and therefore able to harness this positive shift. On the other hand, awareness of the negative effects of unconventional policies does not rule realism on the part of the ECB, with Mario Draghi having announced on 8/10 that euro zone inflation could come close to the ECB’s target of 2% at the end of 2018, start of 2019.