Coffee Break 17.09.2018

LAST WEEK IN A NUTSHELL

  • Among the numerous Central Bank meetings, the Turkish and the Russian Central Banks raised their benchmark rates more than expected, bringing some calm to EM assets. ECB and BoE confirmed their steady course.
  • A “Brexit” deal before the end of the year is becoming more likely than not as the UK and the EU are said to be planning a special summit to sign such a deal, news of which has pushed the GBP further upwards.
  • The inflation data from around the world confirmed our view that inflation is moving up but not sharply, leading the US 10Y to reach 3%.

 

WHAT’S NEXT?

  • Flash September PMIs in Europe and the US will be released, giving indications about the cyclical regional divergence.
  • In Japan, Shinzo Abe is expected to win the Liberal Democratic Party’s presidential election, thereby extending his tenure as Prime Minister by another 3 years.
  • China’s own “art of the deal” is demonstrated by their invitation of Wall Street executives to Beijing to discuss ways to improve relations. However, a date has still to be set for the next round of trade negotiations.
  • “Brexit” will be the focus of an informal EU summit in Salzburg.

INVESTMENT CONVICTIONS

  • Core scenario
    • The US expansion is solidly anchored and accelerates. Hence, the Fed is expected to tighten later this month.
    • European cycle stabilises and momentum is set to accelerate into YE-2018 but growth in Italy and UK is more vulnerable.
    • China is easing its policy mix to mitigate the slowdown and trade tensions .
    • Gradual rise in inflation in the US and in the euro zone, but no inflation fear.
  • Market views
    • US momentum remains strong but does not reveal any excess.
    • The tax reform, buybacks and still attractive valuations vs. bonds have pushed US equities to all-time highs. This is a good opportunity to take some profit and reduce our US overweight.
    • Both EMU and Emerging markets look oversold from a sentiment and flow perspective. Hence, we use the proceeds to increase our exposure to emerging and euro zone equities
  • Risks
    • Trade war: higher tariffs and protectionism could slow down global economies, deteriorate international relations and ultimately corporate margins.
    • Spill-over from Emerging markets country-specific mini-shocks: the evolution of the US dollar is key for emerging countries due to outstanding debt in this currency.
    • EU political risks: euro scepticism could continue to rise as opinions diverge on a growing number of issues, i.e. “Brexit”, Italian budget, US and EU trade negotiations outcomes.

 

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

We are overweight equities vs. bonds via a regional split between US, EM and euro zone equities as we expect the trade conflict to remain contained. We have become neutral Japanese equities as Shinzo Abe is likely to be re-elected by his party. This takes out one significant risk we had identified. We keep a short duration, and expect a stabilisation and possible short-term reversal in the US dollar.

 

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We maintain our equity exposure to overweight as we expect the underlying favourable economic background to prevail in spite of the aggressive trade rhetoric.
    • US growth re-accelerates and global growth momentum outside the US is expected to continue, albeit at a slower pace.
    • We are overweight US equities, but took some profits. The improving earnings growth and the positive impact of Donald Trump’s tax reform and deregulation are a support for the asset class. In addition, valuations are not too expensive. “America first” policy impacting other countries negatively are likely priced in now.
    • We are overweight euro zone equities. The region displays a robust economic expansion and economic momentum appears to have picked-up somewhat while the ECB remains accommodative. We prefer small and mid-caps to large ones as they are somewhat sheltered and are more sensitive to domestic demand and less FX sensitive.
    • We are underweight Europe ex-EMU equities. The region has a lower expected earnings growth and thus lower expected returns than the continent, justifying our negative stance. The outcome of the “Brexit” negotiations are unclear but are moving forward and the issue remains a risk.
    • We are neutral Japanese equities. Japanese stocks show a more positive economic momentum and so we moved to neutral on the asset class. PM Shinzo Abe is highly likely to win the upcoming LDP leadership elections.
    • We are overweight emerging markets equities. Global growth remains strong for the foreseeable future and emerging markets assets as a whole have already build a risk premium for a tightening US monetary policy, a stronger USD and trade war risks.
  • We are underweight bonds and keep a short duration
    • We expect a gradual rise in inflation, but no inflation fear.
    • Global monetary tightening is progressive. Outside of the US, other developed market central banks are in no hurry to tighten, but some EM central banks have been forced to do so to mitigate currency stress.
    • With a tightening Fed and expected upcoming inflation pressures, we expect rates and bond yields to resume their uptrend. In addition to rising producer prices, rising wages, fiscal stimulus and trade tariffs could push inflation higher.
    • The overall improvement in the European economy could also lead EMU yields higher over the medium term. The ECB will remain accommodating but should end its QE in Dec 2018. Mario Draghi sees rising protectionism as a major source of uncertainty.
    • We have a neutral view on corporate bonds overall but prefer EU to US in both Investment Grade and High Yield. Spreads have already tightened significantly and a potential increase in bond yields could hurt performance.
    • Emerging market debt faces headwinds with trade war rhetoric and rising US rates but we believe spreads can continue to tighten from current levels. The carry is among the highest in the fixed income universe. It represents an attractive diversification vs other asset classes