Yves, let's kick off the year talking about bonds. So we've seen that a number of very prominent bond managers have actually called out the end of the bond bull market, while others disagree. What's the view of the bank on this?
Yves Bonzon: There have indeed been some very prominent and loud voices recently claiming the bond bull market that started in the early 80s has come to an end. In making that claim, you're fundamentally and implicitly assuming that fundamentals in the economy have turned around. In other words, the recovery that we are experiencing in the global economy at the moment, and which for the first time since the crisis of ‘08 is pretty broad-based with all countries participating in that recovery, is it of a cyclical or structural nature?
The critical point here is the velocity of money – how fast money is turning in the economy as a function of GDP. The velocity of money has been on a constant decline since the late 90s, late in the last century. Betting on interest rates breaking through current levels on a sustained basis is fundamentally assuming the velocity of money is bottoming and turning around. This would mean the private sector is normalising and private corporations and private households have a renewed appetite for borrowing, and traditional transmission channels of monetary policy are functioning again. I am assessing a 20% probability for that scenario. Unfortunately, the velocity of money has not yet found the bottom, and therefore we are in a cyclical rise in long-term bond yields as opposed to a structural one.
So given the uncertainty, how do you think the central banks will react, and what are the likely consequences of that?
Indeed, the response of major central banks, as a function of whether you believe this recovery is structural or cyclical, will be key for major financial markets and asset classes. Typically, if we are in a structural recovery, it would be important for the central banks to remove excess banking reserves in a pretty hard and fast way. Therefore, faster tightening of monetary policies for those already tightening, and faster removal for those which are still in an easing mode, would be warranted. Conversely, if this is a cyclical recovery, and they tighten monetary policy too fast on the belief it is structural, then we may have a scenario where bond yields stop rising and actually reverse downwards hard, and equities would also experience a significant correction.
So putting bonds to one side and taking a closer look at equities, what do you think the outlook is for 2018 – what should we be mindful of, as investors?
I think we should stay on the alert for signs as to whether this recovery is structural or cyclical. One of the important indicators in that respect will be how the private sector is behaving in the major economies; whether, finally, private sector borrowing is picking up or not. And so, the sector balances, as far as accounting norms are concerned, will be important to monitor. The more interest rates go up, the more the equity bull market will be challenged. We have room, though – the 10-year treasury yield is trading at 2.65% today. I think in the context of a strong recovery, we can easily afford 3% given the current ex ante risk premium that equities are still enjoying versus bonds, and still keep the rally and the bull trend intact. Above and beyond that is a function of how and why we get there.
So speaking of recovery: if we look to Europe, and maybe more specifically at France, we see that a number of the actions Macron is taking – and with the reforms he's implementing – it seems that they're starting to have a positive impact on the Eurozone. Where do you see this heading?
I think France is at a multi-decade inflection point. All the wrong-footed policies that have been implemented, starting with way too excessive regulation of the labour markets, are being reversed for the first time under the current presidency. There is little opposition from unions or political parties to these reforms, and we can already observe that the President is getting his way and getting things done. In a country where, on some measures, government accounts for close to 56-57% of GDP, a little bit of supply-side reform can have a very significant impact on economic activity. And in some respects, you could make the case that France is currently at the same point as where Germany was in the early 2000s, when Chancellor Schröder implemented reforms in Germany. The potential, therefore, for GDP per capita to improve in France and catch up with Germany is very, very significant. This has minor global asset allocation implications as far as traditional asset classes like French equities are concerned. There might be more granular implications in sectors that benefit from faster GDP growth in France, but more importantly, that probably has Euro implications, and we've said for some time, the crisis regime that sometimes affects the European currency has suddenly become dormant and is likely to stay dormant for the moment. Even the prospect of elections in Italy keeps systemic fears in Europe at very low levels. The fact that France is getting its act together, and eventually will turn around for good, is certainly another factor of support for the European currency
So there are some positive signs in France. And, maybe taking this as an opportunity to look at Euro assets in a bit more depth, what do you think we can expect in the year to come?
I think the currency is impacted most by these developments, so the odds that we will go back to crisis regimes in the Euro area further diminish as France improves. Therefore, the scenarios where some were expecting the Euro to trade at new lows, potentially trading at parity with the dollar or below that, seem to be extremely low-probability scenarios. The more likely scenario is a continuation of the recovery. That recovery, though, will be constrained by the fact that an important factor in the Euro area recovery has been the recovery in the periphery countries.
They've made tremendous efforts to improve their competitiveness by adjusting unit labour costs, and a too rapid appreciation of the Euro currency, of course, would jeopardise these gains. Therefore, I think the fundamental direction of the market is leaning towards additional at-the-margin Euro strength, but in a constrained, sort of capped way by the competitiveness at the periphery of the zone.