Coffee Break 12/10/2018

LAST WEEK IN A NUTSHELL

  • Equity and credit markets registered a sharp sell-off, sending European markets to their lowest level since mid-2016.
  • OPEC and their allies have agreed to cut oil production by a larger-than-expected 1.2 million barrels per day, while exempting Iran from cutting production.
  • US nonfarm payrolls added less-than-expected 155K jobs last month, keeping the unemployment rate stable at 3.7%.
  • Global Manufacturing PMI stabilised overall, softening somewhat in the euro zone and accelerating slightly in the US while steadying in Emerging markets.
  • In Germany, the CDU party elected Merkel’s crown princess Annegret Kramp-Karrenbauer as a successor for Angela Merkel, who will remain Chancellor.

WHAT’S NEXT?

  • Inflation and core inflation rates will be published in key countries including the US, Germany and France. This will be the final important input of the year, following a soft US job report.
  • The European Central Bank will meet on Thursday and is expected to stop net purchases under the asset purchase programme at the end of the month.
  • ECB president Mario Draghi is reportedly confident that an agreement will be found between Italy and the European Commission.

INVESTMENT CONVICTIONS

  • Core scenario
    • In the US, we expect growth to be close to 3% in 2018, and to slow down in 2019 due to fading fiscal stimulus, trade policy uncertainties and tightening financial conditions as the Fed maintains its rates normalisation.
    • Outside the US, the economic cycle is less dynamic and hitting a plateau. European momentum is disappointing and policy risks remain.
    • As the US-China relationship appears fractured, China is easing in the face of a slowdown (monetary, fiscal, and currency).
    • The decline in the price of oil should pause the gradual rise in inflation in the US and in the euro zone.
  • Market views
    • US economy remains strong, and does not reveal any economic imbalances. The Fed is however appearing less hawkish and more data dependent.
    • Above-potential growth, the tax reform, buybacks and no valuation excess vs. bonds keep pushing US equities up over the medium term.
    • Based on fundamentals, we see potential for a narrowing divergence between the US and the rest of the world. The various political risks are a headwind.
  • Risks
    • Trade war: The US and China bought three months of time to resolve the structural issues. In the meantime, higher tariffs and protectionism are slowing down global economies, deteriorate international relations and ultimately corporate margins.
    • Emerging markets slowdown: Emerging markets are among the most vulnerable regions when global growth slows down. The evolution of the USD liquidity is also key for the region due to outstanding debt in this currency.
    • EU political risks: Political pitfalls could fuel euro scepticism further as opinions diverge on a growing number of issues, i.e. “Brexit”, Italian budget, social unrest in France and trade negotiation outcome with the US.
    • Domestic US politics: Democrats could slow down Donald Trump’s legislative agenda. Passing legislation will be a result of compromises and “beautiful deals”.

 

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

We remain tactically overweight equities. From a regional perspective, we remain overweight US and euro zone equities. We continue to hold a negative view on the UK, due to the unresolved “Brexit” issues, while being neutral emerging markets and Japan. In the bond part, we keep a short duration and a cautious view on Italy.

 

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We have kept our equity exposure overweight and still have a constructive medium-term view based on fundamentals. 
    • We are overweight US equities. Economic momentum is less favourable as fiscal stimulus boost is fading. We expect slower, but positive, earnings growth in 2019. Fed hiking is a headwind but the slowdown underway could moderate the Fed’s hawkishness as it is “data dependent”.
    • We remain overweight euro zone equities. Slow growth and political uncertainties are increasingly weighing on the stock market. Conversely, any conflict resolution is a potential trigger for a strong rebound.
    • We remain 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.
    • We are neutral Japanese equities. Japanese stocks reflect less domestic risk as “Abenomics” will continue for three more years. The positive economic momentum encouraged us to become neutral on the asset class.
    • We are tactically neutral emerging markets equities. While we believe in the growth of Emerging markets, they are badly hit by the trade war, the developed markets’ slowing growth and the USD strength. 
  • We are underweight bonds and keep a short duration
    • We expect rates and bond yields to keep rising gradually. In addition to rising producer prices, rising wages, fiscal stimulus and trade tariffs could push inflation higher.
    • The expanding European economy could also lead EMU yields higher over the medium term. We expect interest rates to gradually increase. We remain underweight Italian bonds. The ECB remains accommodative, but has confirmed that it will end its QE in December.
    • We have a neutral view on corporate bonds overall as there is little spread compensation for risk. 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 tighten from current levels. The carry is among the highest in the fixed income universe. It represents an attractive diversification vs other asset classes.