Coffee Break 15/10/2018

LAST WEEK IN A NUTSHELL

  • Equity markets experienced a sell-off on Wednesday. We had already tactically amended our equity exposure beforehand, reducing our bias towards euro zone, US and emerging market equities.
  • Besides two macroeconomic risks - the fact that the Fed has little reason to deviate from the gradual hiking path and the hardening of the US/China trade war – there was no fundamental reason for the strong market decline.
  • As this is a fast market, there is a strong need for active and opportunistic management. Beyond valuation, we now see two potential positive performance triggers: the start of the Q3 earnings season and the re-start of share buybacks. We haven’t changed our constructive medium-term view, and we are buyer at lower technical levels.
  • Upward interest rate pressures in the US eased somewhat towards the end of the week, as inflation pressures appeared to cool slightly. In September annualised inflation (CPI) came in at 2.3%, down from August’s 2.7%.

WHAT’S NEXT?

  • Italy will submit a draft of its budgetary plan to the European Commission.
  • The Fed will release the minutes of its last committee, likely showing more colour on the hiking path underway.
  • Towards the end of the week, the EU council hopes to sign off a “Brexit” deal.
  • Both in the US and China, investors will analyse the publication of industrial production figures. In Germany the ZEW economic sentiment survey will catch investors’ attention.
  • Q3 earnings releases in the US will pick up steam, allowing investors to focus on fundamentals.

INVESTMENT CONVICTIONS

  • Core scenario
    • Solidly anchored US expansion. Hence, the Fed maintains its tightening path.
    • Outside the US, the economic cycle is less dynamic, but the momentum is set to accelerate into 2019.
    • As the US-China relationship appears fractured, 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 economic momentum remains strong but does not reveal any economic imbalances.
    • 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 latest IMF estimates showed that higher tariffs and protectionism could slow down global economies more than expected, deteriorate international relations and ultimately corporate margins.
    • Emerging markets slowdown: he evolution of the USD liquidity is key for emerging countries due to outstanding debt in this currency.
    • EU political risks: political pitfalls could fuel euro scepticism as opinions diverge on a growing number of issues, i.e. “Brexit”, Italian budget, German regional elections, trade negotiation outcome with the US.
    • US mid-term elections: after the mid-term election, on 6 November, tail risks of either a tax reform 2.0 and larger deficits (too hot) or the willingness to repeal the tax reform (too cold) could destabilise markets in either way.

 

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

We are tactically neutral on equities vs. bonds. However, despite the increased volatility and more difficult market circumstances, we haven’t changed our constructive medium-term view, and would be buyer at lower technical levels. We keep a short duration and a cautious view on Italy.

 

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We have tactically reduced our equity exposure to neutral, tough maintaining a constructive mid-term view based on fundamentals. We have reduced our exposure towards the euro zone, US and emerging markets equities.
    • We have slightly reduced our US equity overweight, given the current increase in volatility. From a mid-term perspective, the improving earnings growth and the positive impact of Donald Trump’s tax reform and deregulation are a support for the asset class.
    • We have reduced our euro zone exposure, though maintaining a slight overweight. The region displays a solid, although easing, economic expansion and is attractively valued. However, political uncertainties are accumulating.
    • 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. The separation from the EU is approaching but the outcome of “Brexit” negotiations are still unclear.
    • We are neutral Japanese equities. Japanese stocks reflect less domestic risk as “Abenomics” will continue for three more years. PM Shinzo Abe show a more positive economic momentum and so we have become neutral on the asset class.
    • We have tactically cut our emerging markets equity exposure to neutral, looking for lower technical levels to step in again. Global growth remains decent for the foreseeable future and emerging markets assets as a whole have already incorporated a risk premium for a tightening Fed, a strong 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. In this context, global monetary tightening is progressive. With a tightening Fed and expected upcoming inflation pressures, we expect rates and bond yields to keep rising over the medium term. 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. The ECB remains accommodative, but has confirmed that it will end its QE in December. Mario Draghi sees rising protectionism as a major source of uncertainty.
    • We have a cautious view on corporate bonds overall, but prefer EU to US in both Investment Grade and High Yield. 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.