- Extension of USD weakness supportive of emerging and US markets but penalizes Japanese and European assets.
- (Geo)political uncertainties at the forefront, to different extents: North Korea, US tax, German elections, Congress of the Chinese Communist Party.
- Upcoming expansion the second step in global reflation after recovery in 2016.
- Central banks the current central theme.
The global expansion dynamic is well underway.
- The outlook for the world economy appears solidly anchored above 3% growth for this year and next, while inflationary pressures remain subdued. The latest data confirm that both the Eurozone and Japan are expanding above potential in spite of currency-strengthening. Meanwhile, the economic news flow from the US is gradually improving, while emerging markets continue to benefit from stabilising commodity prices, a weakening USD and accommodative central banks.
The political risk has switched from Europe to the US.
- The Italian risk, on a medium-term horizon, is quite clear and appears manageable, while the German elections should not materially alter the outlook for the continent. In the US, there is a risk of legislative delay in pro-growth policies, while the debt ceiling und government funding issues will be back on the table by mid-December. Monetary policy uncertainty due to the upcoming reshuffle of the Fed Board of Governors is adding to the fiscal policy uncertainties.
Central bank dovishness to recede gradually.
- The US central bank has been clearly focusing on balance-sheet management / reduction rather than on interest rates. Meanwhile, the ECB is expected to issue tapering announcements in the near future, in line with the economic robustness in the region. As the Bank will nevertheless continue to take into account the recent rise of the euro, it should come as no surprise to see investor surveys showing monetary policy errors as the biggest “tail risks”.
Tactical and regional portfolio positioning
GENERAL OVERVIEW: Equities vs. Bonds
After another step in the Federal Reserve’s plan to gradually remove its monetary accommodation by reducing its balance sheet, the next step appears to be more controversial. The markets now expect only one-and-a-half interest-rate increases by the end of 2018. This is at odds with the Fed’s own projections of four additional hikes. To our mind, investors have become over-confident about the Fed remaining their friend and seem to be focusing on the low US inflation dynamics. As a consequence, risky assets have performed well, as indicated by the historic highs in equities and historic lows in market volatility.
Looking forward, Candriam would expect the Fed to focus more on financial conditions even if inflation remains low. In any case, given that overall financial conditions are easing, a continuation of the gradual tightening steps taken should not lead to even lower inflation. We note that progress on a 2018 budget resolution and tax reform would result in a more accommodative policy mix. Our investment conclusion is that we remain overall overweight equities while keeping a short duration. More specifically, the current context could be favourable to US small caps, which, during H1, suffered from the soft patch, the USD depreciation and the decline in the new Administration’s legislative credibility.
REGIONAL EQUITY STRATEGY
Positive on equities
- The robustness of the global economic news flow is supportive. As global growth has firmed compared to the past two years, key risks going forward are (geo)political.
From a regional point of view:
- We are neutral on US equities. There is an execution risk in the announced fiscal stimulus and pro-growth policies.
- We are positive on EMU. Q2 GDP data confirmed the ongoing, more robust and geographically broadening economic expansion in the region. An accommodative central bank and a strong corporate earnings momentum underpin the attractiveness of the region’s risk assets, which are no longer subject to a major political risk premium.
- We are negative on Europe ex-EMU. The deterioration in the Brexit negotiations and the difficulties in setting up new trade relations (e.g., with Japan) and their impact on the economy are keeping us away from the region.
- We are positive on emerging markets. They are benefiting from attractive valuations in a robust global growth context. China should not trigger a systemic risk this year and the IMF has revised its medium-term growth expectations upwards (on average, from 6.0 to 6.4% for the years 2017 to 2020).
- We are positive on Japanese equities. Strengthening growth and a supportive domestic policy mix are among the main performance drivers and we are more convinced than ever that the BoJ will not join other central banks in tightening its monetary policy anytime soon, a decision which should ultimately lead to a weaker JPY.
FIXED INCOME STRATEGY
Negative on government bonds, short duration
- With a tightening Fed and expected upcoming inflation pressures, we expect rates and bond yields to resume their uptrend from this month’s low. We expect rising wages and potential stimulus to push inflation higher, although this is taking longer than expected to materialise. Potential US protectionist measures (NAFTA renegotiation, China) are a wild card.
- The improvement in the European economy could also lead EMU yields higher as political risks recede, and the ECB should start detailing the next step in its tapering this autumn.
- We have a neutral view on Credit, as spreads have already tightened significantly, and a potential increase in bond yields could hurt performance.
- On emerging market debt, the ongoing monetary easing represents an important support for this asset class.