Coffee Break 5/2/2017

After the relief rally on the European equity markets following the outcome of the first round of the French presidential election, investors’ attention shifted to both ECB and BoJ meetings last Thursday. Although raising its economic forecasts, the Bank of Japan kept its policy steady with a target yield for the 10Y Japanese government bond at around 0%. The central bank upwardly revised its real GDP forecasts from 1.5% to 1.6% for the 2017-2018 fiscal year, while decreasing its consumer price index growth forecast to 1.4% from 1.5% for the same period. The JPY remained more or less stable, following the announcement.

Meanwhile, the ECB left its accommodative monetary policy unchanged, but mentioned receding downside risks and took note of the euro zone’s economic recovery. ECB President Mario Draghi also pointed out that the likely victory of Emmanuel Macron in the French presidential elections had no impact on the monetary policy decisions. After hitting the day’s peak of $1.093 as Mario Draghi delivered an optimistic statement, the EUR subsequently fell by 0.4% against the USD to hit a session-low given the absence of further policy actions. European markets closed slightly lower that day.

In the US, the release of a one pager on the future tax reform and a soft Q1 GDP report were not sufficient to give a new impulse to markets.

This week, we will closely monitor the FOMC meeting and the run up to the second round of the French presidential elections.

Our current investment strategy on traditional funds:

Legend
grey : no change
blue : change

EQUITIES VERSUS BONDS

We are neutral on equities as we keep a portfolio protection and hold a short duration on bonds:

• The US cyclical expansion, the economic recovery in Europe, the global inflation momentum and decent growth in China are all supportive for equities in a rising rates context. A higher nominal growth is ultimately supportive for corporate profits.
• Central banks’ actions are decoupling but their tone has turned less dovish:
  • The ECB left its monetary policy unchanged, making no changes to its key interest rates or bond buying programme. However, QE tapering should become a central theme after the summer.
  • After the Fed interest rate hike in March, two additional moves are expected this year by the central bank.
• Equities have an attractive relative valuation compared to credit, and their expected return should be boosted by the end of the earnings recession in the US and Europe.
• Oil markets continue their rebalancing. However, while OPEC members are bringing back oil production to more durable levels, US rigs have been re-opening, implying a greater production.
• Political events keep uncertainty levels high. The geopolitical tensions in Syria and North Korea, the US house’s failure to approve the healthcare reform, the UK officially triggering Art.50 of the Lisbon treaty and the French presidential elections, are all implying high dispersion of possible outcome.

REGIONAL EQUITY STRATEGY

• We remain overweight on euro zone equities. Fears of political disruption in France are almost entirely removed and the European political risk premium has receded. This region also benefits from a supportive cyclical expansion and a less mature economic recovery compared to the US. Moreover, the valuation gap between the US and the euro zone is still above average looking at 12 months forward price/earnings, supporting the attractiveness of the region’s risky assets. Also, earnings revisions are positive and should underpin a market rebound. And, finally, international allocators stand ready to put money to work in Europe, which should lead to supportive fund flows.
• In the UK, with the official notification that the country would leave the European Union, we maintain an underweight position on equities. Although the upcoming elections announced by Theresa May present little risk, the uncertainty surrounding the “Brexit” negotiations can potentially weigh on the British economy.
• Our exposure to US equities is just below, but close to neutral. We are waiting for more clarity on fiscal stimulus and see the gap between survey optimism and actual activity as a tactical warning on US equities. US stock markets have benefitted from post-election optimism among consumers and businesses but activity has yet to follow sentiment. The expected fiscal stimulus should support the earnings outlook further but there is an execution risk as the Trump administration did not deliver any realistic details regarding the tax reform so far.
• We have a neutral exposure on Japanese equities. Stronger global growth and a supportive domestic policy mix are among the main performance drivers, but a weaker currency is warranted to gain more conviction.
• We hold an overweight on emerging market equities, with India as our preferred market.

BOND STRATEGY

• We maintain our underweight on bonds and keep a short duration. With a hawkish Fed and continuing inflationary pressures, we expect interest rates to maintain their uptrend. The improvement in the European economy could also lead euro zone yields higher, barring political risks.
• We continue to diversify out of low/negative yielding government bonds:
  • We have a neutral view on credit, as spreads have already tightened significantly and a potential increase in bond yields could hurt performance.
  • We remain positive on inflation-linked bonds as we expect a rise in core inflation by fiscal easing, higher wages, less deflationary pressure in China and the prospect of protectionist measures. Potential US protectionist measures are a wild card.
  • We maintain a relative value strategy: long German Bund / short French OAT ahead of the second round of the French presidential election. We see the strategy as a hedge against the European political risk.
  • We have a slight overweight in emerging market debt, both in local and in hard currency terms. The carry remains attractive and negative financial implications of the US presidential elections, due to a stronger USD, are receding.
  • We are close to a neutral high yield exposure. The spread compression has exceeded our targets on both sides of the Atlantic, but the carry remains attractive.
  • On the currency side, we hold a lower underweight on GBP ahead of the upcoming British elections. Prime Minister Theresa May surprised markets by calling a snap general election in June in order to secure political unity to support her “Brexit” plan. According to the latest polls the conservatives would win with around 43% of the votes.

• In US, initial jobless claims increased by 14,000 to a seasonally adjusted 257,000 vs a Reuters consensus forecast of 245,000. The labour market is close to full employment, with the rate at a near 10Y low of 4.5%.
• The Michigan Consumer Sentiment index stood at 97 in April, slightly up from 96.9 in March and below a Reuters consensus estimate of 98. The reading still shows a high level of optimism about personal finances.
• In the euro zone, the economic sentiment indicator rose by 1.6 in April to 109.6, its highest level for nearly a decade. The increase was broad-based across sectors, including industry and retail, and across countries.
• In Germany, flash consumer inflation accelerated by 2% YoY in April, following a 1.6% rise in the previous month and above market consensus of a 1.9% gain.
• Euro zone inflation flash estimate hit 1.9%, returning to the ECB’s target of below, but close to 2%. 

EUROPE

Positive week for European equities.

• European markets began the week on a high note, following correct predictions about the outcome of the first round of French elections.
• The fading of French political risk meant the CAC and high beta indices, such as IBEX and FTSEMIB, outperformed on a return of the risk on/reflation rally.
• Halfway through the earnings season, the Stoxx 600 companies that had reported by the end of the week had delivered a positive average earnings surprise of 9.5%.
• Oil and Gas stocks underperformed following the slumping crude price.

US

US markets boosted by European news flows

• The bullish wave that came after the French elections crossed the ocean and boosted Wall Street.
• The iconic earnings report of Alcoa, regarded as a solid indicator, was welcomed by the markets, as it beat the estimates.
• The technology index Nasdaq reached a symbolic all time high of 6000 points, with a YTD performance of more than 12%.
• But markets were restrained by the many question marks staying in the White House: lack of visibility on tax reforms, tensions with Korea, Obamacare successor, etc.

EMERGING MARKETS

Chinese industrial profits surged.

• Chinese industrial profits rose by 24% in March, far above expectations.
• Hong Kong gained more than 2% over the week.
• The other main hot topic in Asia remains the geopolitical risks, in particular the tensions between North Korea and the US. Donald Trump had some discussions with its Asian partners, in order to find a consensual answer to the latest military operations of Pyongyang. 

RATES

The ECB kept all its key rates and guidance unchanged last Thursday.

• Mario Draghi acknowledged the strengthening recovery but remained prudent on the inflation dynamics.
• Inflation data released in Europe came out higher than expected: Headline and Core inflation respectively bounced back to 1.9% Yoy (1.8% anticipated) and 1.2% (1% anticipated) reflecting higher oil prices and Easter effect.
• In the US, the GDP growth was somewhat weaker than expected.
• 10Y US, UK, Japan and German yields stood at respectively 2.3%, 1.07%, 0% and 0.32%.

CREDIT

Busy week on the credit market with risk-on sentiment dominating, post-positive French elections.

• Significant spread tightening both on cash and on derivatives markets.
• Senior and Sub Financials tightened by -8bp and -20bp while Main and Crossover tightened by -8bp to -23bps.
• AT1 and insurance outperformed the rest of the capital structure and T2s remained well bid throughout the week.
• Overall, AT1 closed up 2-5pts, bank T2 15-35bps tighter and senior 2-15bps tighter on the week.

FOREX

Despite quite dovish ECB stance the EUR kept jumping versus all major peers thanks the positive momentum after the first round of the French elections and solid economic data in the euro zone.

• The worst performer last week was the NZD on concerns that US trade tariffs could be extended to other countries such as New Zealand and Canada.
• EM currencies started the week higher on risk-on sentiment, but gave up their gains due to the USD strength. 

COMMODITIES

Energy weakened over the course of the week, with crude only edging very slightly lower.

• US DoE inventory stats showed a bigger draw than expected for crude oil, which helped to prevent an excessive reaction to Libya increasing output.
• Base metals edged higher despite deleveraging in China.
• Precious metals weakened as sentiment improved post the French elections, with Treasury yields rising and the USD strengthening.