Coffee Break 6/24/2019

LAST WEEK IN A NUTSHELL

  • Central Banks gave a new impetus to financial markets, sending bond yields and the USD lower, while the S&P 500 soared to a new record high. As it is not about the data but about mitigating prolonged risks, the Fed and the ECB will likely join the global easing cycle sooner rather than later.
  • Flash June PMI revealed ongoing strength in services at 53.4 for the euro zone. Manufacturing PMI rose by a marginal 0.1 to 47.8, but it remains below 50 for the fifth consecutive month.
  • In the UK, the race to Number 10 is reaching its final round. Boris Johnson (Brexiteer) and Foreign Secretary, Jeremy Hunt (formerly a Remainer) are the last 2 contenders. Now the Conservative Party’s 160,000 grassroots members will pick the winner by 22nd July at the latest.
  • EU heads of State adopted the EU’s new Strategic Agenda for 2019-2024 and gathered for talks over the European Commission and ECB president candidates. No agreement was met on the latter yet. 

 

WHAT’S NEXT?

  • Central banks pass the baton to politicians. While the G20 has a full agenda mentioning the importance of digitalisation and protecting the environment, all eyes are on the US and Chinese presidents as Donald Trump and Xi Jinpin are expected to have dinner on Saturday.
  • EU heads of State will hold a summit to decide over the European Commission and ECB presidents.
  • The starting gun for next year’s US presidential election will be fired as twenty contenders for the Democratic presidential nomination are due to debate over two nights. Donald Trump officially started his re-election campaign last week.
  • On the data front, the main event will be the May PCE inflation report in the US. It is expected to be below the Fed’s inflation target and should not represent an obstacle to rate cuts. Other important data include the German IFO business climate and the preliminary May durable and capital goods orders in the US.

INVESTMENT CONVICTIONS

  • Core scenario
    • We have a moderately constructive long-term view but are aware of political pitfalls, in particular the re-ignited trade and technology tussle, which might last.
    • As the business cycle is hit by prolonged uncertainty on trade, central banks have stepped up rhetorics to prepare for monetary easing, contributing to a fall in bond yields and rising equity values. 
    • In Emerging economies, the measures taken by Chinese authorities to support the economy might be stepped up in order to show their impact.
    • In the euro zone, the economic cycle remains less dynamic: on average over 2019, GDP growth is expected to be at 1.3%.
  • Market views
    • Stabilizing or improving macro data would likely lift global bond yields whereas chilling business activity and the escalating trade conflict will jeopardize confidence in the recovery.
    • The readiness to act of the Fed and the ECB pushed equity values upwards. The last FOMC validated a July (pre-emptive) rate cut and Mario Draghi is mentioning additional stimulus measures unless conditions improve.
    • Equity fund flows remain negative in recent weeks: investors are staying increasingly cautious given the current context. Recent fund manager surveys were the most bearish since the 2008 crisis. Cash has been raised and equity reduced.
    • European and Japanese equity valuations are below their historical average, whereas US and Emerging markets are close to long-term averages.
  • Risks
    • The US – China trade conflict is at the top of the list. It could further weigh on output growth and trigger further spikes in volatility. We expect this to be a lasting issue, beyond trade.
    • Geopolitical issues (e.g. Iran) are still part of unresolved current affairs. Their outcome could still tip the scales from an expected soft landing towards a hard landing.
    • Political uncertainty in Europe (European institutions, Italian public finances, “Brexit”, limited margin of maneuvre) remain.

 

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

We stay overall neutral equities with a regional tactical bias: overweight US equities vs underweight UK. We are neutral everywhere else. In the bond part, we keep a short duration and we continue to diversify out of low-yielding government bonds via exposures to credit and Emerging markets debt in hard currency. In terms of currency, we keep a long JPY position as a hedge, and recently sold the USD versus the EUR ahead of the Fed meeting.

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We are neutral equities
    • We are overweight US equities. We think there is still a Trump put in addition to a Fed put, which makes the region a safer choice.
    • We are neutral Emerging markets equities. The US Fed’s willingness to cut rates is a tailwind for the region but the trade war is a major hurdle. We still have a growth expectation above 6% for China this year.
    • We are neutral euro zone equities. We expect a rise in the equity market but are aware of the restraining factors such as the vulnerability of global trade. The labour market and domestic demand remain decent. Most foreign investors have left the region, leading to a consensus underweight in spite of cheap valuation.
    • We stay 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. Hard “Brexit” risk has increased in recent weeks.
    • We stay neutral Japanese equities. Absence of conviction, as there is no catalyst. The region could catch up if the news flow around international relations improves and global growth renews with more traction.
  • We are underweight bonds and keep a short duration
    • We expect rates and bond yields, especially German 10Y yields, to rise gradually from depressed levels.
    • A slower but still expanding European economy could lead EMU yields higher over the medium term. There is an unfavourable carry on core and peripheral European bonds. The ECB might be adding more accommodation and will add a new TLTRO.
    • Emerging market debt has an attractive carry and the dovish stance of the US Fed represents a tailwind. Trade uncertainty and idiosyncratic risks in Turkey and Argentina are headwinds.
    • We diversify out of low-yielding government bonds, and our preference goes to US High yield, as a dovish Fed, low inflation and receding recession fears point towards the carry trade.
    • We downgrade the USD as it should stop appreciating as the Fed starts easing its policy.