All of a sudden, the US is in a sweet spot as growth accelerates, inflation falls, the Fed eases and both presidential candidates are ready to spend massively. By contrast, the rest of the world appears concerned about geopolitics and growth. While support for growth would be welcome in the Euro area, it is urgently needed in China – and authorities have finally started to lay out comprehensive measures. These actions offer the prospect of a more favourable growth/inflation mix and have propelled equity indices to new highs, with the Chinese equity index gaining over 20% in September. For the time being, we have chosen to align ourselves with improving fundamentals and are overweight on equities, while maintaining a long duration on European fixed income.
Improving fundamentals
After stabilising last month, various macroeconomic releases began to improve in September, notably in the United States. Data revisions in the US have pointed to GDP growth above 3.0% during Q2, while this level of growth has also been confirmed by leading indicators for the third quarter. In other words, the US is growing about 100 bps above its growth potential for the past six months and we would be surprised if the upcoming earnings season deviates from the well-established adage “guide low, deliver high”.
In China, authorities seem to be finally addressing the mounting deflationary pressures by announcing a raft of monetary and fiscal measures. The September Politburo meeting highlighted the importance of supporting the economy, which underlines the sense of urgency.
So far, the announced fiscal measures are expected to provide support worth only 0.2%-0.3% of GDP but they should help China move closer to its 2024 target.
These measures are a first step in the right direction, but the amount of support remains insufficient to put China’s economy on a sustained path out of deflation. Press leaks suggest that more fiscal support will be announced in the coming weeks. Clearly, the stimulus announcements have been noticed by investors, despite current persistent economic headwinds and deflationary pressures.
In the Euro area, some support for growth would also be welcome. We certainly do not expect a major fiscal initiative – witness the underwhelming reception of the Draghi report on the future of European competitiveness calling for common debt issuance in the region. Furthermore, the steady rise in massive deficits and debt-to-GDP ratios has made public debt a staple of the financial press and it is once again becoming a political issue, as seen by the opening of excessive deficit procedures. In 2025, there will likely be no getting around the issue of fiscal rebalancing in developed countries, which should weigh on growth.
As a result, further monetary policy easing by the ECB has become likely: headline consumer price inflation hit 1.8% in September, representing its lowest level since April 2021. As the fight against inflation should represent less of a challenge than the fight against economic stagnation, markets expect the short-term interest rate to fall below the inflation rate next spring. After being restrictive for some time, monetary policy in the Euro area could see an expansionary shift by then.
Earnings have been the main trigger of equity performances so far
Improving fundamentals have therefore shifted the narrative for bond and equity investors once again.
Bond investors have repriced the amplitude of Fed easing (i.e. less than expected just weeks ago) and of ECB easing (i.e. more than expected just weeks ago). The greenback has strengthened somewhat as a result.
Equity investors too have been eager to integrate the improved news flow on current and future activity. The S&P500 index has been breaking above the 5800 level and has now been up for five straight weeks, tying its longest winning streak of the year. Clearly, the bull-run has been supported by the rise in profits as growth remained stronger than thought in the US and is expected to benefit from new fiscal and monetary support in China and a less restrictive monetary policy in Europe.
An open race in the US
Of note, investors appear to have sidelined the US election and be concentrating on improving fundamentals for now. We observe that prediction markets have tightened, showing the two camps almost level.
Furthermore, the tipping-point state most likely to provide the marginal electoral vote to the winner – Pennsylvania – currently has no leader.
In less than three weeks one of the most dramatic and chaotic presidential campaigns in modern US political history will have come to an end: one last-minute replacement in the Democratic campaign, two assassination attempts directed against the Republican candidate, several switches in election polls frontrunner… Empirical observations indicate that the uncertainty usually subsides after the election and the promises made by the future new President may generate an end-of-year rally.
Our current equity positioning is overweight
In light of improving fundamentals and easing financial conditions, supporting activity and markets, we have become increasingly positive on equities in recent weeks and hold an overweight stance. We increased the allocation to reflect the latest developments in the United States and in China. In China, we became tactically positive on the country and the broader Emerging Markets region to benefit from the current momentum.
Within EMU, we are focusing on sectors that could benefit from the measures announced in China and lower interest rates from the ECB, i.e. luxury and real estate.
More generally, we also like the defensive healthcare sector, which continues to benefit from innovation and profit growth, which remains uncorrelated from the business cycle.
Our current bond positioning benefits from lower policy rates
In the fixed income allocation, we prefer core European bonds such as Germany’s for carry: government bonds are an attractive investment as they do also offer a hedge in a multi-asset portfolio. We therefore currently hold a long duration exposure with a focus on German bonds, also diversifying into UK Gilts, while we are neutral on US duration.
We also see little room for credit spreads to tighten and remain neutral on corporate investment grade. We are more cautious on global high yield and hold a relatively small exposure to emerging markets’ sovereign bonds amid very narrow spreads.
Overweight stance on equities
The global easing cycle and the actions of central banks offer the prospect of a more favourable growth/inflation mix and have propelled many equity indices to new highs.
Our positioning reflects our conviction in improving fundamentals: we are overweight on equities, while maintaining a long duration on European fixed income.
Preference for US and Emerging Markets
In the US, growth caution is vanishing and the Fed is going above and beyond what is needed. We are overweight on US equities.
In China, the People’s Bank of China and the government have joined forces to restore confidence, laying out comprehensive measures and boosting activity. We are overweight on Emerging Market equities.
In the eurozone, economic growth remains weak and political uncertainty is here to stay. Support offered by further ECB cuts will be welcome. We keep an overall neutral stance on the region’s equity markets.
We are tactically neutral on Japan. The country is enjoying structural tailwinds but further yen strengthening and emerging political uncertainties could be a challenge.
Preference for Healthcare – Technology remains tactically neutral
We are positive on the Healthcare sector, with earnings improving and performance less dependent on broader economic conditions.
We are buyers of European Real Estate, which should benefit from lower interest rates.
We are neutral on the Tech sector and hold some US small and mid-caps.
Safe bonds resume their portfolio protection role as inflation normalises at cooler levels
Government bonds are an attractive investment following the recent uptick in yields as they offer carry and a hedge in a multi-asset portfolio. Also, we see little room for credit spreads to tighten further.
We maintain a long-duration bias via Germany, focusing on quality issuers. We are beginning to re-enter UK Gilts as yields have picked 50 bps in a month, offering an attractive entry point.
We are neutral on US duration.
We have a small exposure to Emerging Market sovereign bonds amid very narrow spreads.
We are neutral on investment grade and high-yield bonds, regardless of the issuers’ region.
A broadly neutral currency allocation pending central bank cuts and US elections
EUR: The EUR faces uncertainty over its activity and could see a rapid monetary easing.
USD: Markets have re-adjusted to Fed rate cut expectations, which represents a tailwind for the greenback.
JPY: We have reduced our long position on the Japanese yen.
AUD/CAD/NOK: We have taken profits on the AUD following its rise in August.