The interest rates rise bet

The Lazard Equity Expansion fund, aiming to benefit from a rise in European interest rates, was launched in late August. Co-fund manager Axel Laroza details his expectations.

Macroeconomic activity within the European Union will rebound strongly and will correct the deflationary risk, leading to a gradual rise in European interest rates.

That is the thinking behind the investment strategy of the Lazard Expansion Equity fund that was recently launched by Lazard Frères Gestion, as Axel Laroza, co-fund manager, explains.

“We have been facing a unique economic phase since 2008 with severe slowdowns happening. These were combined with systemic risks that have arisen or not. On the financial side, the best example remains Lehman Brothers’ collapse.

“Regarding sovereign debt, the systemic risk climax was a Grexit scenario, which finally did not materialise.”

Laroza adds that this “abnormal” situation should not last because the low rate environment reflects a systemic and deflationary risk within the Eurozone that will correct on a long term perspective, rather than Europe economic fundamentals.

He underlines that the correction already began back in 2011, when markets priced in the risk of a Eurozone implosion. The situation was repeated subsequently with the Grexit threat even though both cases cannot be compared, he points out.

The fund invests either in companies that will be positively impacted by the rise of European interest rates or those entirely decorrelated from such developments; companies seen as undervalued with bright prospects.

The portfolio includes 30 to 60 European stocks, relying on a stockpicking approach. Large caps whose valuation exceed €2bn account for 75%, and the remaining 25% are small/mid caps. It targets outperformance of its benchmark, the Stoxx Europe 600.

Laroza depicts the fund’s process as a rocket with four stages, each one corresponding to a phase in the way rates will, according to Lazard Frères Gestion’s view.

“First, long term interest rates will increase. As a second step, we see a steepening of the curve due to low short term interest rates and a hike in long term interest rates. We can then expect inflation occurring in Europe. The rise of short term interest rates will be the fourth stage,” he sums up.

During the rise of long term interest rates, Laroza says the fund will play financials equities. One reason for this is in the restarting of structured product issuance activity by banks.

“For now, rates are low and zero coupon bonds are expensive. Investors are not interested. The issuance of structured products accounts for a major share of bank activities. With long term interest rates rising, this activity will start again. It is currently 20 times less important than in 2008,” he highlights.

As for the steepening of the curve, the fund is likely to invest in the banking sector and capital goods.

Even though the current environment seems less favourable than it was at the start of 2015 for European equities – which in the third quarter have faced their worst quarter since 2011 – Laroza remains positive.

“Markets have exaggerated their fears of a global economic slowdown that could have been fed by China’s crisis in the summer, and US macro figures that are a little disappointing in regard to market expectations. Yellen’s
statements have generated amalgams and the Volkswagen scandal brought some volatility as well,” he says.

“China’s slowdown is stronger than expected. However, we remain convinced that the Chinese government will implement the right measures to speed up growth.”

In his view, a fall in European long term interest rates to lower levels than currently, and contrary to Lazard’s bet, would be worrying.

“That would mean markets anticipate a strong slowdown in European activity.”

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