Europe is a real cause for concern, according to State Street’s Michael Metcalfe and Bill Street despite the tail risks seen at the beginning of the year, such as high valuations, seemingly sidelined for now.
Indeed, new issues including a trade war with the US and higher inflation means Europe continues to give investors sleepless nights.
The region can’t seem to stay out of the headlines at the moment and has most recently been reluctantly dragged into US president Donald Trump’s trade war.
While this is certainly an issue – and does seem to be the biggest tail risk in global markets right now – the pair highlighted there are other issues with Europe concerning them.
Starting with the macroeconomics, State Street Global Markets' global head of macro strategy Metcalfe said Europe has been a source of disappointing growth data, particularly in Germany and the industrial sector.
However, over the long term, Metcalfe is more worried about the European Central Bank (ECB), he noted.
While the US Federal Reserve has made a return to normal monetary policy, the ECB has yet to end its quantitative easing program or raise interest rates this year.
Metcalfe admitted that while even the Fed won’t have enough “ammunition” when the next recession comes despite rate hikes, his real worry is what the ECB can do in the next downturn as its normalisation of monetary policy is going very slowly.
“I think there’s a much bigger, longer-term risk in Europe, which is at some point the cycle will roll over. We haven’t defeated the cycle, no one thinks that,” he said.
“But what we do know is that historically, the ECB has needed 400 basis points of quantitative easing in a recession. I can guarantee you they won’t have that in the next downturn, and also its QE is highly constrained.”
The bearish outlook on Europe had therefore caused Street, who is head of investments for Europe, the Middle East and Africa (EMEA) at State Street Global Advisors, to lighten up his exposure to European equities.
On the flip side, he likes US risk assets and said he’s leaning towards large caps and, to a degree, small caps in the region.
US equities have performed particularly well in recent years with the S&P 500 up 39.54 per cent in the past three years. Street said he is surprised by how well US equities have done because there has been so much scepticism surrounding the US regime.
Emerging markets is another area that State Street’s head of investment for EMEA likes at the moment.
“We like the emerging markets from a risk and value perspective although we’re still being a little bit cautious as we travel through current events,” he said.
Year-to-date performance of emerging markets
Source: FE Analytics
Year-to-date, emerging markets have seen a period of underperformance and are down 3.09 per cent. After two years of strong performance, investors are debating at the moment whether this is just a blip or if it is the start of a bear market.
Turning to bonds, Street said that the core bond market in Europe – the German bund market – has extremely low interest rates.
Meanwhile in Italy – the fourth-largest bond market in the world – there is an unstable political environment with the recent elections casting more doubt on the country’s future within the European Union (EU).
“Those combinations never feel particularly good as a bond holder,” he said.
Street said that if you look at Italian bonds today, they are trading closer to the (now emerging market-rated) Greek bond market than to the Spanish bond market.
The spread between Spain and Italy has widened significantly, so bond investors are being very discriminatory about how they’re currently buying into the peripheral bond market, he said.
“The fact that the Italian bond market is trading very close to the European high yield market tells you all you need to know,” he said.
However, Street did say there was one relieving factor to this narrative, which is the fact that the Italian bond market has a big domestic investor base and is basically supported by Italian institutions in a similar way to the Japanese market.
Italian 10-year government bond yield
Source: Bloomberg
And despite all of the negativity, Street said there are reasons for investors to consider bonds moving forward.
The main one is that they are a good diversifier for a portfolio, particularly in the US where Treasury yields have slowly picked up seemingly under the radar.
He said: “If you looked at the GFC [global financial crisis], there was only one security or one asset class that had pure diversification benefits in the crisis and that was the long end of the treasury market. It’s the only asset class that actually gave you correlation benefits.”
Outside of the US, even the German bund market within European bond market can offer diversification despite the low yields.
“[This is] because the peripheral prices didn’t give you that sort of protection. So, we’re buying into that slowly as more of a diversifying agent,” he said.
Street added that he particularly likes shorter-end duration in the credit market but is being cautious because we’re coming to the end of the credit cycle.
“High yield gives you a much lower-duration exposure but you’ve got to balance that off with credit risk exposure. I think, although we’re lightening up on US high yield at the moment, there are benefits in there. There are short-duration high yield products out there which take your duration even shorter,” he said.
“We run one of the largest short-duration ETFs and its very, very popular because you extract all the duration and you just get a spread.”