Quarterly Investment Strategy  

30/12/2016

Asset Allocation: Change in market sentiment: too far too fast?

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Donald Trump’s election to the US Presidency has been cheered by investors. We maintain a constructive view on the reflationary macro environment, which is favourable to risk-taking.
Going forward, given the sharp re-pricing that has already taken place in financial markets, we will be carefully monitoring the two risks to this trend: US dollar strength and protectionism.
OPEC ’s decision to cut production should put a floor on oil prices – supporting our recently-initiated long position in commodities.
Intensifying protectionist threats are testing recently renewed investor confidence in emerging assets. We remain overweight based on improving fundamentals and the stabilisation of the commodity complex.

The major surprise of the past quarter was Donald Trump’s victory in the US presidential election. Thus far, market reaction has been much more supportive than expected with investors focusing on the reflationary aspects of his program. US equities are experiencing all-time highs and base metals are finally recovering from five years of bear market and investor disinterest. In this flow-driven environment, valuation and fundamentals could be set aside for some time while sentiment and positioning take the driving seat. That said, considering the large rallies that have already occurred, the questions for this quarter are whether markets are overreaching reality and which investments stand to further benefit from the changed economic picture.

By “overreaching” we mean market performance that is not fully justified by fundamentals – at least as they can now be objectively projected. Generally, this happens because a large number of investors feel compelled to reallocate portfolios at the same time. Currently, the event behind this “herd” behaviour is Donald Trump’s election. While it is widely agreed that his presidency should bring a mix of tax cuts, deregulation, infrastructure investment, more self-interested foreign policy, protectionist measures and healthcare reform, the details of this mix are still unknown and the end impact on fundamentals difficult to assess. Investors have clearly opted for an optimistic bias.

Starting with equity markets, the post-election euphoria stands in stark contrast to pre-election fears of a disruptive program. Admittedly, our US macroeconomic scenario has been revised up significantly, from a late-cycle to a reflation story. A cut in corporate tax rates is the most consensual element of the President-elect’s program and should therefore be the easiest to enact. Combined with recovering revenues, it should boost corporate earnings and drive up stock prices. Even though US equities are already at new highs, they have only barely moved out of their recent range. Over coming months, we expect the new President’s first policy implementations to add legs to the rally – and have accordingly upped our exposure. Specifically, we would highlight a preference for small- and mid-capitalisations that are currently most affected by elevated US taxes and, thanks to domestically-skewed revenues relative to larger capitalisations, should be less hurt by protectionism and/or a stronger US dollar – the two main risks in this new market environment.

Flows and positioning should also support equity markets globally, with the Great Rotation called for by many over the last couple of years perhaps finally materialising in 2017. Regional differentiation is nonetheless to be expected. The threat of greater protectionism will likely limit the upside potential of emerging markets – although they remain strategically attractive given low valuations and improved earnings dynamics. We maintain our underweight stance on European markets in view of the heavy political agenda lying ahead. We would, however, not be surprised to see them recover later in 2017, once the protectionist risk associated with the French elections and the uncertainties regarding emerging economies’ recovery have been removed – or at least dampened. Finally, Japanese equities stand to benefit from a weaker yen, leading us to consider a more balanced stance.

This changing environment should put the Fed at centre stage. Recent US data strength argues for a more hawkish stance even before the first steps of the Trump reflationary program are taken – perhaps explaining the just announced 25 basis point rate hike. But the task will be challenging for Janet Yellen since an overly aggressive monetary policy would send the US dollar and yields to new highs, nipping the cyclical boost in its bud. That said, the weakening fiscal backdrop, with US budget deficits set to rise in coming years, the mitigation of deflationary fears and greater uncertainty around the path of Fed hikes argue for higher term premia, i.e. rising yields on intermediate and longer maturities. In Europe, the very dovish tapering of the ECB’s quantitative easing program from April 2017 onwards constitutes another underlying cause for a steepening of the yield curve, easing the pressure on banks. As regards inflation-linked markets, we see limited upside given the still extremely low level of real interest rates. With the oil price rally unlikely to exceed USD 60 per barrel for any length of time, US breakevens should stabilise (more on oil below). Yields currently seem relatively fairly priced, even if risks remain skewed to the upside. We thus maintain our underweight on developed market sovereign bonds.

In the credit space, higher financing costs induced by higher sovereign yields are likely to be somewhat offset by the corporate tax cut. Despite elevated leverage, coverage of interest expense should thus remain sufficient to avoid a surge in defaults. The high yield segment should also benefit from an improved outlook in the energy and materials sectors, considering recent developments in commodity markets. We thus feel comfortable with our overweight stance on high yield – less sensitive to rate moves and more sensitive to the business cycle than investment grade credit (where we remain neutral).

As alluded to above, rapid US dollar appreciation could pose a risk to US corporate earnings. So while greater fiscal stimulus, repatriation and protectionism obviously stand to support the greenback, we expect the Fed to attempt to temper its strengthening. That said, continued ECB asset purchases, even at a slightly reduced pace, should keep the euro weak relative to the dollar. The Swiss franc is also liable to strengthen against the euro in the event of heightened Eurozone political risk. Finally, the British pound trajectory should continue to depend on the attitude adopted by the British and European authorities in the “Brexit” negotiations. In short, we thus have a positive stance on the USD and CHF, a neutral stance on the EUR and GBP, and expect the JPY to remain under pressure.

Emerging currencies are likely to continue to be volatile against the dollar, especially when it comes to the Mexican peso and the renminbi (the Trump campaign having explicitly threatened Mexico and China with import tariffs of respectively 35% and 45%). A scenario in which China retaliates by ending its intervention in currency markets cannot be excluded – with potential contagion to the rest of the emerging space. Domestic fundamentals should however help emerging currencies stabilise as 2017 progresses, supported by an improved outlook for commodity markets. Pending greater clarity on Donald Trump’s ability to implement the foreign policy that he promoted during his campaign, we have reduced our exposure to local currency-denominated emerging bonds, while remaining strategically overweight. Nevertheless, we recognize that greater dispersion between emerging currencies is probable, according to their dependency on US imports and their sensitivity to commodity markets.

Indeed, commodity markets have been the best performers of the last few weeks, supported both by the US presidential election (potential impact of an infrastructure plan on base metal demand) and the OPEC deal (accelerated rebalancing of the oil market). The long position on global commodities that we initiated in the wake of the Trump victory thus bore rapid fruit, boosted by the ensuing OPEC agreement. Are these moves also overreaching fundamentals? For now, we do not share such a view but will be monitoring developments closely.

OPEC members’ production cuts suggest a rebalancing of the oil market as soon as the 1st quarter of 2017 – a process accelerated by the additional reductions announced by non-OPEC members (mainly Russia, alongside ten other countries such as Mexico, Oman and Azerbaijan). The oil market should thus be in deficit shortly, requiring refineries to draw down inventories earlier than expected. In the past, such action would have supported oil prices for some time. The emergence of US shale production has, however, changed the backdrop. Able to increase their output much more rapidly than traditional actors, shale companies have become the swing producer – meaning that oil prices eventually converge towards their marginal cost. With shale production to resume gradually as hedging opportunities above USD 55 per barrel arise, the upside on oil prices will likely be capped. So while market sentiment and investor positioning should continue to be supported by sound energy fundamentals in the short term, US supply side evolution warrants close watch. The same holds true for base metals which have been reinvigorated by the President-elect’s intention to implement a large-scale infrastructure plan. This will add to the Chinese stimulus already in place, fuelling positive demand momentum. Sentiment has thus improved markedly and investors who had neglected these markets for several years seem to be rediscovering their inflation-hedging ability. That said, from a fundamental standpoint, the picture is far from being homogeneous across commodities. Nickel and zinc markets should for instance be quite well balanced while copper and steel might continue to face oversupply, another reason for careful monitoring of this call. Finally, gold has been under pressure since the US election and consequent surge in real rates (more than 30 basis points), approaching the lower end of our USD 1,150-1,350 per ounce range – despite rising geopolitical risks. We keep our neutral stance: supply – demand fundamentals are still negative (with production costs well below the current price) but renewed financial demand cannot be excluded once yields stabilise. 

To conclude, our main portfolio adjustments following Donald Trump’s election pertained to emerging market exposure. While we are still believers in the strategic story, we cannot exclude further volatility, especially on the currency side. Pending clarity on that front, we elected to steer our exposure towards domestic US equities and commodities, the prime beneficiaries of the most credible aspects of the President-elect’s program (corporate tax cuts and infrastructure investment). What new risks does this new environment bring? A marked strengthening of the US dollar and/or a global trade war initiated by US-imposed protectionist measures could threaten our portfolios. Keeping watch of the central banks’ response and the global trade environment will be key in 2017.

Hedge funds: light at the end of the tunnel?
The investing environment has been challenging for the hedge fund industry. At this point, however, we believe that the increasingly apparent limits of monetary policy and concurrent shift towards fiscal stimulus should create a volatile environment with more directional opportunities. Macroeconomic, policy and political dispersion between regions and countries is on the rise. Hedge fund managers, particularly in the macro segment, should benefit in 2017.

 

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