The US economy is in expansion and experiencing the longest cycle ever to the benefit of US investors and the local population. Political risk could be on the horizon with the upcoming mid-term elections in early November 2018.
In the euro zone, the key word is “resilience” and momentum has turned favourable. We are witnessing stabilizing PMIs – if we exclude Italy and Great Britain – and there has been a steady rise in economic surprises since June. There is still a big question mark over the automobile sector, with potential new tariffs impacting several countries, including Germany.
However, the recent pick-up in IFO German manufacturing export expectations and in business expectations indicates that business owners overestimated the impact of potential additional tariffs. Trade fears are now priced-in – at least to some extent. The euro zone is also subject to political risks such as the Italian budget negotiations and the loaded political agenda for this autumn, with key dates related to the Brexit negotiations.
In Japan, fundamentals are improving. The country is renewing with positive earnings and growth, and political risk is dissipating. Ongoing fiscal stimulus and an accommodating Bank of Japan are impacting the country positively. While some investors have left, the country has proven to be resilient.
In the emerging markets, the trade war is dominating the news flow and USD evolution is a key risk. However, our research shows that the number of “vulnerable” countries, in terms of private and government debt relative to their 2018 Q1 GDP, remains relatively small. In China, the Yuan has lost 10% vs. the USD in recent months and should remain at the bottom of the current range in the short term. The Chinese authorities have also introduced fiscal easing measures to offset the slowing growth. The positive impacts are expected in early 2019. If, for now, the impact of additional tariffs from the US on their GDP is manageable, investors’ sentiment and outflows will nonetheless be closely monitored.
In conclusion, emerging markets and European equities have suffered from investors’ outflows, as investor sentiment has deteriorated to the benefit of the booming US. Nonetheless, they will eventually have to comply with the strings attached to their expansive monetary and fiscal policies. Hence the regional divergence has also opened up performance gaps and opportunities for a catch-up. The unknown short-term variables should not weaken the attractiveness of the solid, domestic and economic fundamentals in both Europe and emerging markets. In this context, we shall definitely stay constructive on equities based on the good fundamentals. Economies are growing, the business cycle keeps moving forward and valuations are attractive in other asset classes. Our 1-year expected returns are close to double-digit growth for our preferred regions, which are concentrated in the US, in combination with a tactically overweight euro zone and emerging markets. In the meantime, we maintain some cautiousness on credit and a negative tilt on bonds, with the exception of inflation-linked bonds and emerging market debt. The main risks to our scenario include US trade policy, the spillover from emerging market shocks, European political risks and the approaching mid-term elections in the US.