Taking advantage of global re-synchronisation

By Sophie Chardon, Cross-Asset Strategist

Grégory Lenoir, Head of Asset Allocation

Risky asset markets remained broadly well-supported during recent months. Although the summer lull was punctually interrupted by escalation in the US-North Korea rhetoric and the tropical storms, pullbacks were contained. Rebounding economic data, particularly in the Eurozone and emerging economies, fuelled a global re-synchronisation, with most countries simultaneously in positive growth territory for the first time since 2007. As such, growth assets such as equities, emerging markets and industrial metals gained traction. Our longstanding exposure to both emerging debt and equities, further strengthened by the implementation of our new Strategic Asset Allocation framework in September, has thus been rewarded. Going forward, we think that the current financial backdrop is here to stay and expect more continuity than disruption in our investment positioning over the coming quarter.

Normalisation of the Fed balance sheet will start as soon as this month but, although definitely an event from an economic textbook standpoint, we do not expect it to be particularly disruptive when it comes to the US yield curve and the fixed income space in general. It has been well publicised and its potential impact on markets should be gradual (academic studies estimate upward pressure not to exceed 20 basis points (bp) per annum, all things being equal). After a couple of months dampened by low inflation prints, markets recently revised up their US rate expectations, on the back of both a more hawkish Fed and President Trump’s renewed reflationary push. Strikingly, European yields only partially retraced their downward trend. In particular, the 10-year Bund yield remains 10 bp lower than it was when Fed tapering was first announced. Short-term rates are anchored below zero and limited supply can be brought forward, but we would still expect upward pressure in coming months when details of the tapering are revealed.

Turning to credit, performances were mainly driven by rate moves. Spreads widened some during the summer but tightened again in September when markets returned to risk-on mode. The economic environment should remain supportive for the corporate space. We also note that commercial banks are taking over companies’ financing needs, preventing a surge in corporate defaults.

Finally, we continue to favour emerging market local currency debt. Beyond the attractive carry, we feel comfortable with the long-term prospects for currencies that have depreciated heavily against the US dollar during the last few years. Decreasing inflation is also allowing some central banks to adopt a more accommodative stance.

Major currencies, and specifically the EUR/USD pair, continued to be a main focus in recent months. The relentless appreciation of the single currency against the greenback was halted mid-September by the disappointing German election outcome and President Trump’s reflationary tax cut proposal. With our medium-term EUR/USD forecast of 1.25 in mind, we took advantage of this pullback to strengthen our USD hedges in European portfolios.

The Swiss franc continues to suffer against the euro. With the Swiss National Bank (SNB) to lag behind the ECB in normalising policy (the inflation picture remains structurally depressed in Switzerland), we see more upside than downside risk on the EUR/CHF over the medium term. The amplitude of the move will, however, likely be limited by the euro position on the SNB balance sheet that should ultimately be reversed.

Finally, the British pound’s recent appreciation is rather surprising from a fundamental standpoint, with economic activity only muddling through and Brexit negotiations underway. That said, the hawkish stance adopted by the Bank of England at its last meeting warrants relative currency strength in coming weeks.

Turning to equity markets, we see the current macroeconomic backdrop as supportive for our risk-on stance. US equities may look expensive from a valuation standpoint, but, in the current stable growth and positive but contained inflation environment, we do not consider that to be a sell signal so long as earnings dynamics remains robust. And, although we expect final figures to be revised down after weeks of political negotiations, the tax cuts just proposed by President Trump will improve the earnings outlook for domestic small- and mid-size companies.

In Europe, sales and earnings expectations were revised down for the fourth consecutive month, on the back of the stronger currency. Mid and small capitalisations saw lesser downward earnings revisions than large ones, due to the domestic bias in their revenues. Although European markets did suffer from this revised outlook, it is worth mentioning that, in currency-adjusted terms, they outperformed their US peers, buttressing our regional positioning. Furthermore, after two months of consolidation, we think that the effects of euro appreciation have been factored into asset prices and, going forward, expect robust domestic dynamics to again support Eurozone earnings.

Beyond attractive valuations, emerging markets are benefitting from the regionally improving economic backdrop. For the first time since 2011, the 2nd quarter saw MSCI EM index components report double-digit earnings growth, a trend that should continue this year and into 2018 according to analysts. Emerging Europe boasts a notably benign outlook, helped also by the positive growth momentum in the Eurozone. We thus maintain our positive bias towards the region, with exposure further strengthened in September by the implementation of our new Strategic Asset Allocation framework.

Commodities continue to post positive returns: oil fundamentals are improving in line with our expectations, and industrial metals have showed impressive price action carried by emerging demand. The three-month outlook for commodity prices is generally positive, now that industrial and precious metals have retraced some of their strong summer gains.

In the oil sector, we see the consequences of the recent hurricanes as short-lived while the underlying positive dynamics should prove robust. US production is rolling over, suggesting that shale companies are revising down their capital expenditures with WTI (West Texas Intermediate) futures trading around USD 50 per barrel. After a couple of above-target months, compliance with the ongoing OPEC/non-OPEC (Organization of Petroleum Exporting Countries) output agreement also improved in August, while most agencies raised their oil demand estimates for 2017 and 2018. Oil upside will nonetheless be capped by the additional supply that could be triggered by WTI prices significantly exceeding shale production costs.

Finally, gold contributed to commodities’ outperformance, benefitting from geopolitical concerns. Still, we expect it to remain in our USD 1,100-1,300 per ounce range, as US yields gradually move up.

All told, our current positioning is very much a continuation of past quarters, remaining in risk-on mode and preferring emerging assets to US assets, and risky assets to “safe” assets. Barring geopolitical risk, we identify two potential game changers that could significantly challenge our baseline scenario in coming months: EUR/USD overshooting and successful US tax reform. While the latter might be most detrimental in terms of relative positioning, we see the former as most disruptive in terms of absolute performance.

Indeed, a EUR/USD rising above, say, 1.30 by year-end, would not only far exceed its fundamental value, but the extreme pace of appreciation implied (almost 25% over one year) would afford companies little time to adapt their financing. It would not be sustainable for export-driven sectors, eventually threatening the Eurozone recovery. As such it would trigger outflows from European equity and debt markets. The outflows would not necessarily extend to emerging markets, for whom a weaker US dollar would be supportive.

Our second risk factor, an above-expectations US tax deal, could lead to faster tightening of monetary conditions and a stronger greenback, eventually hurting emerging and commodity exposure – while supporting US equities. Hedge funds managers should, however, be able to take advantage of greater sector and regional dispersion.

Changes to our Strategic Asset Allocation

As of September, our portfolios have structurally higher emerging market, small-cap equities and corporate debt exposure. We adjusted our Strategic Asset Allocation (SAA) to account for key new structural trends, and reflect world of lower expected growth and investment returns. The SAA is the backbone of a multi-asset portfolio, designed to support it through the full business cycle. Although we usually comment on our tactical positioning in this publication, meaning our reaction in terms of portfolio positioning to the medium-term financial outlook, we intend to briefly expose here the changes made to our SAA.

As fundamental investors, we acknowledge the fact that the returns of many traditional asset classes are dampened by today’s environment of low but stable economic growth with controlled inflation on the one hand, resulting from ageing demographics and low productivity, and more “normal” monetary policies on the other hand. We thus assessed prospects across a broad spectrum of traditional and less traditional asset classes, so as to expand our opportunity set. Crucially, we believe that emerging markets and credit (corporate rather than government debt) will be important factors in driving future returns. As a result of this remodelling, our SAA now incorporates the following:

• Reduced cash holdings – to increase the possibility of generating higher returns.
• Reduced government bond exposure and increased high-yield bond exposure – to seakbetter risk-adjusted returns within the traditional fixed income space.
• Increased emerging market  exposure – both equities and local/hard currency debt – to benefit from past multi-year underperformance, relatively low valuations, higher structural growth rates and undervalued currencies.
• Introduction of small-cap equities – tapping into a new source of equity returns and an “illiquidity premium”, or compensation for investing in more thinly traded equity markets.
• Introduction of convertible bonds – tapping into a new source of equity and credit-like returns.
• Introduction of Swiss-listed real estate in Swiss franc portfolios – to benefit from an “illiquidity premium”, or compensation for investing money over long periods of time.

Should we fear high equity valuations? 

By many measures, stock markets can currently be considered overvalued. Since 2012, price-to-earnings ratios have risen continuously on the back of expansionary monetary policies, especially in the US. Late 2016, equity multiples stretched further, on optimism regarding pro-business policies by the US Congress and Administration, much of which remains in planning stage. As a result, traditional valuation ratios now stand close to decade highs, albeit lower than the levels reached during the Internet bubble.

In our view, the ongoing shift in economic paradigm towards structurally lower growth and interest rates means that past valuation metrics may not be a good guide for the future. Notably, price-to-earnings ratios seem sensitive to the inflation regime. Using very long-term historical data provided by Professor Shiller, we find that an economic environment of positive but contained inflation – typically between 1% and 3% –  supports higher valuations than extreme inflation regimes such as deflation or hyper-inflation. As such, the current “soft goldilocks” market environment (i.e. low but stable growth, with positive but contained inflation) tends to favour higher valuations. As do the improved global macroeconomic outlook and the richness of other asset classes such as credit or government bonds.

We would thus not consider current equity valuations as a bearish signal per se. Instead, we expect this backdrop to prevail so long as earnings dynamics are robust. The last earnings season saw most companies significantly exceed expectations. Going forward, our outlook for the US economy supports a continuation of this trend. Depending of the final size of tax cuts, 2018 US earnings estimates might even be lifted. More importantly, the current global re-synchronisation warrants sustained earnings momentum for the quarters to come.