June 09, 2014

Stewart Richardson
Chief Investment Officer
The ECB delivered on its promise of action at last weeks meeting and, if anything, slightly exceeded expectations with such a clear we are not finished statement. Equity and
bond markets rallied strongly and there is a feeling among some analysts that there could be a summer melt up in equities. Although our work has indicated for some time that,
for the long-term, equities are expensive and bonds offer little value, the market action was extremely strong post the ECB meeting. Our tactical view is that there is no point
standing in front of this particular runaway train and therefore we are mostly long European equities and bonds. With such financial repression from the ECB, investors will feel
impelled to chase yield further.

Our main conclusion from the ECB is that the new round of stimulus is as much about trying to weaken the currency (a 10% move in the Euro impacts inflation by 0.5%) as it is
about trying to increase lending to the real economy. We have discussed the FX markets a lot in recent weeks and so will not repeat ourselves again today. Suffice to say, the fact
that the ECB delivered on its promise for action and remains willing to do whatever it takes, should be a headwind for the Euro over time.
Of course, other factors influence currency rates and with two and with five year yields across Europe (except Portugal and Greece) below those available in both the US and UK,
there should be less of a desire for non EU investors to pile capital into Europes bond markets which appears to have been a significant cause of strength in the Euro last year.
In the US and UK, as opposed to Europe, talk is increasingly of rate rises at some point next year. Furthermore, the short squeeze in bonds in April and May appears to be over and
we now expect the whole curve in both the US and UK to shift higher which should be supportive of the Dollar and Sterling over time. The US employment report at the end of
last week continues to indicate an economy capable of about 3% real growth (see chart below) and it is simply not prudent to expect yields to remain near 2.5% in that
environment.

Bond yields should track nominal rather than real growth and we suspect that the US economy can generate growth somewhere in the 5% range in the next few quarters (3% real
plus 2% inflation). In this environment, the FOMC has no choice but to end QE (probably in October) and lay out their plan to raise interest rates in 2015. As shown in the chart
below, whenever 10 year bond yields (in red) remain below nominal GDP for too long (late 1990s and in the years before the financial crisis) trouble is usually not too far away in
the form of rising rates. Either bond yields rise or nominal GDP needs to fall in the months ahead. Either scenario would see an increase in volatility which, as we have shown in
recent weeks, is close to all-time lows and also associated with troubled times ahead.
- See more at: http://www.marketviews.com/ecb-delivers-bumper-package/#sthash.u81CXUGD.dpuf