Coffee Break 9/24/2018

LAST WEEK IN A NUTSHELL

  • Markets were not surprised by the US announcement of a 10% tariff on additional USD200bn Chinese imports, effective this Monday.

  • The risk-on mode was fuelled by Shinzo Abe’s governing party leadership win, validating 3 more years of “Abenomics” and an accommodative policy mix.
  • European leaders met in Salzburg to discuss migration and the UK’s exit from the Union. In spite of little progress on the Irish border issue, the GBP strengthened, supported by strong retail sales.
  • The September flash PMI of the US and the euro zone were released and showed the persisting regional divergence whereas both remain in expansion territory.

WHAT’S NEXT?

  • Focus will be on the Fed’s statement accompanying its expected 25bp hike: Will the assessment drop the term ”accommodative”, signalling a more dovish stance looking forward?
  • Germany will publish its monthly IFO business climate figures, a bellwether for the European economy, in particular after the sharp rise in August.
  • The European political agenda is fully packed: Italy will release its Economic and Financial Document Update and Turkish President Erdogan will be on State visit in Germany.

INVESTMENT CONVICTIONS

  • Core scenario
    • Solidly anchored and accelerating US expansion. Hence, the Fed is expected to tighten this week.
    • 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 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 global expansion to continue in spite of trade tensions. We keep a short duration and remain positioned for the 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. 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 solid economic expansion and economic news flow 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.
    • We are neutral Japanese equities. Japanese stocks reflect less domestic risk as “Abenomics” will roar on for three more years. PM Shinzo Abe show a more positive economic momentum and so we remain neutral on the asset class.
    • 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 accommodative but should end its QE in December 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.