2018 will be all about navigating volatile investment waters

In a nutshell

• Coming into 2018, we shared our view that last year's high equity valuations were consistent with the so-called “goldilocks” economic backdrop, but rising uncertainties pertaining to inflation and monetary policy would likely dampen the outlook – 1st quarter financial market volatility was a case in point.
• An extension of the positive trend in global trade remains the backbone of our pro-risk asset allocation.
• Economic overheating, fuelling a significantly higher cost of capital, and an intensification of protectionism are the two risks to our baseline scenario.

Despite the strong economic backdrop, and after record performance in January, market waters have been choppy of late. February saw the VIX index, the commonly-used measure of equity volatility, move back above 35 – a level not seen since the commodity and renminbi crisis of August 2015. In a context of inflation and monetary policy normalisation, the surge in US real rates appears to have triggered the market rout, joined more recently by concerns about trade tensions, internet privacy and general political discord. In effect, we see this quarter as having marked the return to a new (more normal) volatility regime, in which nimbleness and investment discipline will be key.

We still expect the positive trend in global trade to extend into 2018 and further underpin cyclical assets and sectors. Risks to our baseline scenario lie in economic overheating, fuelling a significantly higher cost of capital, or an intensification of protectionism. As regards interest rates, our take is that the US 10-year real yield can rise a further 80 basis points (bps) before hurting equity markets (see Box B, page 12). As for the protectionist threat, we still consider President Trump's rhetoric to be primarily a negotiation tactic, with limited odds of translating into a global trade war. The numerous exemptions on steel and aluminium tariffs finally afforded by the US buttress this view. Also, even though recent retaliatory measures by Chinese authorities are ground for concern, the world's largest two economies do currently appear to be open to further dialogue – albeit on an equal footing (see Box A, page 11).

For now, our pro-growth stance remains valid, justifying an overweight position in equities. The strong 4th quarter 2017 earnings season was a testimony to robust global fundamentals. Companies in the US, Europe and Japan delivered upside surprises, high single-digit sales growth and double-digit earnings per share (EPS) growth, along with a positive outlook for growth and capex. Some leading indicators have admittedly started to roll over, from historically high levels, but this comes as no surprise after more than 18 months of an almost uninterrupted upward trend. The supportive global macroeconomic backdrop makes it unlikely that corrections translate into a bear market. With a 2018 price-to-earnings (P/E) ratio below 17x for the S&P 500 and at 14x for the Euro Stoxx 600 (see chart X, page 9), we see episodes of volatility as buying opportunities – of which we recently took advantage to increase our equity exposure.

Regionally, emerging markets and Japanese earnings stand to benefit most from this global backdrop (see chart XI, page 9), with emerging markets also supported by their ongoing domestic recoveries and an improved outlook for the commodity complex. In Europe, now that the Italian election risk is behind, we expect markets to recover, on the back of attractive valuations, a very supportive domestic-driven recovery (our 2018 European GDP forecast is consistent with double-digit EPS growth) and lesser currency headwinds. The US market, most advanced in the business cycle, should be more prone to profit-taking: valuation upside is limited, and the level of interest rates may become more challenging. At the sector level, current investor concerns are fueling volatility and profit taking in IT after four years of outperformance and in what had become an overcrowded long positioning. We would not, however, call into question the secular trend underpinning IT valuations. Style-wise, interestingly, our preference for small capitalisations has proved successful. Despite a historically higher beta, their domestic bias appears to have shielded them, to some extent, from trade war fears.

Given the sensitivity of global equity markets to perceived US risk, we treaded cautiously in increasing equity exposure. To keep our global risk profile in check, we elected to also increase cash holdings. Indeed, we continue to see little hedging capacity in the bond space, preferring to maintain government bond exposure at a minimum level while moving underweight in credit markets.

The US 10-year yield has risen by some 40 bps year-to-date, to near 2.8%. Unlike what occurred in the latter half of 2017, most of this move is attributable to the real rate component (see chart XII, page 10). Yields surged through mid-February, before pulling back over the past couple of weeks, as IT-related turmoil drove some demand for the relative safety of government debt. Going forward, the normalisation of inflation expectations around 2.1% (as per the US 10-year breakeven rate) appears well-advanced, and now in line with our baseline scenario. US markets have priced in Fed guidance of three rate hikes this year. There is still some room for market repricing as pertains to 2019 and beyond, but investors will want to assess the stance of the new FOMC (Federal Open Market Committee) before reviewing their medium-term expectations. That said, structural forces, such as lower potential growth, are likely to prevent a sharp rise in interest rates and drive further flattening of the US yield curve next year. Still, even with US interest rates close to what we consider fair value, we believe it is probably too early to add exposure, particularly since additional pressure may come from Europe during coming months. Ever since the ECB initiated its asset purchase programme, European long-term yields appear to have been extremely disconnected from fundamentals. Some normalisation did occur in January and February (with the German 10-year real rate up 40 bps), but most of the move was then undone in March on global trade war fears. This overvaluation of core European yields should reverse once the current market turmoil eases and the ECB can start to prepare markets for a normalisation of its policy. Against this backdrop, peripheral debt should offer better prospects on a relative basis.

With benign financial conditions supporting corporates and preventing a surge in defaults, we continue to prefer credit over sovereign bonds. That said, the attractiveness of the asset class has deteriorated. Indices' duration is at historical highs (5.4 currently in Europe, vs. 3.8 in 2012), increasing the vulnerability of the asset class to interest rate volatility. As such, we think a risk-adjusted equity-cash position offers better relative value than holding credit.

We continue to see greater value in convertible and emerging bonds. Convertible bonds' risk/return profile is attractive in the current market environment, since they stand to benefit from their exposure to equity bull markets, while the value of the option tends to rise during episodes of volatility, not to mention the lower duration of the bond. As for emerging debt, stable growth and subdued inflation should allow central banks to maintain a generally accommodative stance (Russia, South Africa and Brazil even cut rates in March). With the US dollar likely to stabilise in coming quarters, investors should make a rapid comeback. After all, emerging bonds constitute one of the last pockets of returns in fixed income.

The currency space is where we see greatest stability for the months to come. After falling sharply in January, the US dollar is stabilising. With the market now largely pricing in the upcoming ECB tapering and improved Eurozone growth prospects, the euro looks less undervalued. We see no catalyst for further appreciation until the ECB starts to discuss its interest rates policy (our EUR/USD 1.25 medium-term target is maintained). In Switzerland, with inflationary signs absent, a change in central bank stance appears unlikely over the next few months, keeping the Swiss franc directionless against the euro. The two biggest outliers in terms of valuation are the British pound and Japanese yen. While the former should remain highly dependent on Brexit news flow, we have initiated a long position on the latter. Last quarter already, we highlighted the striking asymmetry between a very crowded short trade and significant valuation upside. Given the pick-up in economic activity and inflation expectations, the BoJ's very accommodative stance will likely be questioned during the course of 2018. The short USD/JPY position implemented in January has proved successful, first on a weakening dollar, then on a strengthening yen – confirming its traditional safe-haven status. Going forward, we maintain this position, expecting more comments from BoJ members about the potential exit strategy (our USD/JPY medium-term target has been revised down to 100). The JPY remains significantly undervalued according to purchasing power parity (see chart XIII, page 10).

Finally, commodities have proved resilient to equity market turmoil, providing the hoped-for diversification effect despite their high beta status and vulnerability to de-risking by systematic strategies. The Brent oil price is fluctuating around our medium-term target of USD 64/barrel, but recently benefitted from greater geopolitical risk (and a potentially tougher stance by the newly appointed US foreign policy team on Venezuela and Iran). Gold has enjoyed renewed investor interest, as evidenced by ETF holdings. As for base metals, speculative positioning on copper fell sharply during the volatility spike. Going forward, commodity performances at large should be driven by supply developments (OPEC – Organization of Petroleum Exporting Countries – and US shale producers in the oil market and capital expenditure cuts in base metals), implying a lower correlation with equities than in the past, while the downside should be limited by the favourable demand backdrop. We thus maintain our slight overweight.