NN IP: Income theme returns - ECB remains dovish

Income is trending again

The income theme is back in markets. On the back of signs of a rebounding global economy and hopes of additional stimulus in the US, markets started to “reflate” last year. Interest rates rose, inflation expectations jumped and financial and (non-commodity) cyclical sectors outperformed within equity space. Meanwhile, “search-for-yield” and “low-vol” plays in global markets clearly lagged, while bond markets also suffered. Despite Brexit and the Trump election, a sense was building in markets that the global economy would finally break through its growth ceiling of the last five years and accelerate into a 4% running speed.

Given the pressure that growth acceleration would generate on increasingly scarce resources in labour markets, the wage and inflation risks shifted up in the minds of investors. Also, the idea that monetary policy could be normalized more quickly than anticipated started to build. Not surprisingly, investors therefore started to demand bigger risk premiums in global bond markets. Also, asset classes with more leverage on growth and links to cash flows that accelerate non-linearly in a 4%-growth world started to outperform the “income” assets whose returns are largely driven by coupons and dividends. 

Against a background of a broadening of the global cyclical recovery, rising stimulus expectations, falling unemployment rates and rebounding inflation rates the “reflation trade” ran through markets from the second half of last year until the first quarter of this year. Since then, however, its force tapered out a bit. The cyclical recovery is still there and continues to support growth-sensitive areas in global equity markets, like emerging markets and Europe or non-commodity cyclical sectors. At the same time, however, economic data have stopped to surpass expectations (see Figure 1) and inflation numbers (and expectations) have started to peak out in recent months. Moreover, hope of substantial fiscal stimulus and growth enhancing supply side reform in the US has faded sharply in recent months. As a result, the prospect of a further acceleration in global growth is being called into question and the search for income generating asset classes has partially come back on investors’ minds.

This has translated in a recovery in bond markets and the relative performance of income generating equity sectors like telecom and utilities. It is also is visible in the renewed appetite for fixed income spread products like emerging market debt and high yield which have seen healthy inflows again in recent months. Steady growth, increasing participation of the EM region, low defaults and accelerating profit growth are just a few reasons that continue to support these asset classes.

The only real headwind is valuation concerns, as spreads over government bond yields of EMD and HY are clearly tight by historical standards. Anecdotes of leveraged funding structures and lenient investment criteria of investors have started emerge. The resulting risks from this need to be monitored closely obviously, but both fundamental and behavioural drivers of investor decisions over the next weeks and months do not hint at a change in market trends during that period.

For now it seems that the income theme is trending again in markets. While not moving away from a modest risk-on asset allocation stance, it does feel prudent in this environment to rebalance within our risky asset exposure from growth to income. After scaling back somewhat in commodity and real estate space in recent weeks, we now increased our overweight in spread products from small to medium. The perspective of a further reflation of the global economy has certainly not disappeared, but the speed at which it will happen and the degree to which price and wage trends will participate in the process have become a bit more unclear. As a result, a more balanced growth-income theme in our allocation stance seems the best place to be at this point.

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