Asset Allocation: 2017 momentum to continue, but…

LOcom_AuthorsLO-Chardon.png   By Sophie Chardon, Cross-Asset Strategist
Grégory Lenoir, Head of Asset Allocation   LOcom_AuthorsLO-Lenoir.png


The broad-based acceleration in global manufacturing activity has  buoyed risky assets since the last edition of this quarterly letter. A large majority of equity markets are set to end the year with positive – often double-digit – performance. As such, markets are heading into 2018 with strong momentum, but also with demanding valuations, in what could be a more challenging environment. Indeed, as pointed out in our macroeconomic outlook, the extension of this cycle is likely to lead to some (long-awaited) inflationary pressures. Also, the normalisation of the Fed balance sheet, a historical first that will gain traction in coming months, will gradually withdraw a major market participant from the US bond market. Even if we expect these pressures to remain under control, we cannot exclude some episodes of volatility as investors question the implications of such momentous changes in the market environment.

We expect the positive trend in global trade to extend into 2018 and further underpin cyclical assets and sectors (see chart XI). Within equities, emerging market earnings should be strong beneficiaries of this trend, especially the Asian IT (information technology) sector which accounts for an increasing share of global indices. Other emerging exposure, financials notably, should also be supported by the ongoing domestic recoveries in those economies. European markets will continue to enjoy a very supportive domestic-driven recovery. The consensus still seems somewhat conservative, underestimating economic momentum and thus earnings growth (see chart XII). Our 2018 European GDP forecast is consistent with double-digit EPS (earnings per share) growth (versus the 9% consensus), which should trigger positive surprises in coming quarters for both small- and large-caps. We thus continue to overweight European equities, especially relative to US markets with our currency outlook suggesting less negative feedback from the euro. The US economic recovery is already very mature, making for less impressive, albeit still positive, earnings dynamics and little room for operating margin expansion. The same holds for the Japanese economy, where we thus maintain a neutral stance – recognizing, however, that the ongoing recovery in global trade might support further positive earnings revisions going forward.

We are aware that our outlook on equities and ensuing regional positioning is dependent on US tax reform. We expect 2018 returns for US large-caps to range from 5% to 13% according to the extent and timing of implementation. The tax cuts should support earnings growth but valuations are likely to deflate once the one-off effect has been priced in. The chief impact should come at the sector level, with the most domestic sectors seeing the greatest benefit and health care, IT and materials being only very marginally affected. In terms of style, small-caps have exhibited high sensitivity to this theme since President Trump’s election (see chart XIII), as they are the companies that actually pay the statutory tax rate – larger capitalisations tend to achieve lower effective tax rates.

Prospects look less buoyant when it comes to the fixed income space, where our baseline scenario suggests little to no returns, while the normalisation of inflation and monetary policies could be a source of volatility. That said, structural forces such as lower potential growth and the appeal of US Treasuries to international yield-seeking investors are likely to prevent a sharp rise in interest rates. Also, while we foresee two further rate hikes, the Fed’s own guidance for a very long-term Fed funds rate of 2.75% should cap potential market moves at the long-end of the curve. As such, the US yield curve is likely to flatten further next year. In Europe, more steepening is instead to be expected, as long-term yields have appeared extremely disconnected from fundamentals ever since the start of QE (see chart XIV). Indeed, the current economic environment would be consistent with real rates 100 bp (basis points) higher. We think that the overvaluation of European core yields should reverse once the ECB starts preparing markets for interest rate normalisation.

We continue to prefer credit over sovereign bonds as benign financial conditions support corporates and prevent a surge in defaults. That said, the attractiveness of the asset class has deteriorated with future expected returns looking subdued (there is limited spread compression potential from current levels in both the investment grade and high yield segments). In addition, indices duration is historically high (at 5.4 currently in Europe versus 3.8 in 2012), increasing the vulnerability of the asset class should our risk scenario of volatile interest rates materialise. We see greater value in the emerging bond market, and took the recent market consolidation as an opportunity to strengthen our exposure (see chart XV). Stable growth and subdued inflation will allow emerging central banks to maintain an accommodative stance. With the US dollar foreseen as stable during coming quarters, investors should make a rapid comeback, as emerging bonds constitute one of the last pockets of returns in fixed income markets. We thus maintain our overweight in local currency-denominated emerging debt while having recently initiated an overweight stance in the hard currency segment, which now offers a better outlook than investment grade bonds in our baseline scenario.

We also recently adapted our portfolio positioning in favour of convertible bonds. Whereas corporate bonds present limited upside, convertible bonds bring exposure to equity bull markets. Another attractive feature is the increase in the option value in the event of higher volatility, not to mention the lower duration of the bond.

All told, with interest rates likely to trend higher at least in Europe, the core issue from a portfolio construction standpoint is the declining hedging capacity of government bonds. Over the last two decades, high quality government bonds were defined and widely used as a diversifier within a traditional multi-asset portfolio, thanks to their strong negative correlation to equity markets. This is no longer the case, especially in Europe where the danger is much greater with the coupon on 10-year German bonds providing almost no cushion (50 bp). In our view, commodities constitute one of the asset classes that should offer the best diversification and hedging capacities in 2018. Performances are likely to be driven by supply developments (OPEC – Organization of Petroleum Exporting Countries – and US shale producers in the oil market – see Box B, page xx – and capex 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 commodity overweight despite expected returns having been reduced by the impressive price action witnessed last quarter. The potential diversification effect of the asset class looks interesting, particularly in a period of rising geopolitical risk (energy and precious metals) and potentially higher inflation (energy and base metals).

Finally, major currencies might play a less important role next year in a context of monetary policy re-synchronisation, at least when it comes to the Fed and the ECB. With the nomination of Jerome Powell at the helm of the Fed virtually ensuring continuity in US monetary policy, we see no big catalyst likely to question US dollar stability in the short-term. Medium-term, our outlook remains unchanged: we still expect the euro to head higher against the US dollar (our 1.25 medium term target is maintained) on improved growth prospects for the Eurozone. We do not see the Bank of England hike as the start of a monetary tightening cycle given the challenging real economy situation, although recent progress in the Brexit negotiation process might alleviate near-term pressure on the pound. In the absence of inflationary signs, a change in the Swiss National Bank (SNB) stance appears unlikely during the next few months, keeping the franc weak against the euro. The downside appears limited though, as the SNB might take the opportunity of a weaker currency to sell some of the foreign reserves accumulated over the past years. Finally, the yen should remain under pressure as the BoJ is one of the last remaining accommodative central banks. That said, we are starting to see some asymmetry in this positioning. With the present pick-up of economic activity and expectations of higher inflation, this very accommodative stance might gradually be questioned over the course of the year, a prospect that is not priced in by market participants (see chart XVI).


Breaking down the emerging equity index

We initiated an overweight position in emerging market equities in July 2016. Since then, the region has posted a strong outperformance, gaining more than 30% in absolute terms. By many measures long emerging exposure now appears consensual, and valuations have become more demanding. The recent break in the MSCI Emerging Markets index’s momentum (the benchmark for an equity investment) suggests that the re-rating is well advanced. Going forward, earnings growth should be the main driver of performance. 

As such, we have dug further into the index breakdown to highlight the underlying drivers of past performance. First, we found that regional and sector weights have changed dramatically since 2014, when commodity markets collapsed. Asia has always accounted for over 60% of emerging markets’ capitalisation. But this bias has been amplified – to 75% presently – by the sharp fall in commodity share prices, at the expense of both Latin American and Eastern European capitalisations. From a sector perspective, the obvious implication is that the index is now extremely biased towards IT and financials, with the consumer discretionary sector also growing in weight. Conversely, the energy and materials sectors are now less represented. All told, then, emerging equity indices have experienced a profound shift towards the Asian IT sector (semiconductors in Taiwan and Korea, internet in China) (see chart XVII).

One consequence is that their future performance should be less influenced by the very volatile commodity markets and more correlated with the US stock market and the global business cycle.
A second consequence, as regards the 2018 outlook more specifically, is that both engines should be at work: 1) secular IT growth is here to stay – although the pace may slow down compared to the impressive earnings-driven price action of 2017; 2) improved global trade and stabilized commodity markets should support ex-IT earnings.


OPEC acting as the oil market stabiliser

OPEC and non-OPEC participants (Russia) met on 30 November 2017 and agreed to extend their production cuts through year-end 2018, with the goal of normalising inventories. The group made clear that it wants to act as a market stabiliser, limiting oil price downside in the short- to medium-term and generating a favourable backdrop for a return of foreign capital towards the conventional oil sector.
In many respects, a parallel can be drawn with modern central bank communication strategies. Given the relatively stretched market positioning ahead of the meeting, how the decision would be communicated was crucial – and successfully managed. Recent interviews indicated that while a broad agreement to extend the cuts was in the making, Russia had yet to endorse Saudi Arabia’s proposal for a nine-month extension. They could have waited until March to make a decision, but the 14-member OPEC and its outside allies, accounting for close to 50% of the global oil supply, preferred to show a strong commitment, rolling over their production cuts until the end of 2018 – an attitude that resembles the “forward guidance” used by central bankers to anchor market expectations. With the situation in the oil market evolving fast, in particular as regards the potential US shale response to this healthier price environment, the next meeting scheduled for June 2018 will offer oil producers an opportunity to reassess the need for these cuts – a kind of “data-dependency” typical of central bank speeches. The cherry on the cake came from Nigeria and Libya: previously exempted from the deal, they agreed to limit their production to its 2017 level. And it is precisely the growth in those two countries’ production that fuelled oil price volatility earlier this year. Finally, interestingly, OPEC president Al-Falih declined to talk about any exit strategy during the press conference, focusing instead on the efforts required to achieve the inventory draw target of over 150 million barrels – just like Mario Draghi kept the ECB’s asset purchase program open-ended when announcing its tapering.

We see this meeting as the confirmation that oil diplomacy and economic rationale prevail despite recent geopolitical tensions. Saudi Arabia, Russia, UAE and Kuwait are the biggest contributors to the production cuts and they need to ensure oil price stability. The Kingdom of Saudi Arabia has both huge financing needs and the Aramco IPO scheduled for 2018, while the Russian economy remains very dependent on oil prices.

We believe that OPEC is bound to remain in a market-management mode for the foreseeable future, which is good news as we enter a period of seasonally weaker prices.

Short-term, while the technical and fundamental factors underpinning the oil market will most likely remain supportive, the upside seems limited from these levels. Inventory draws, strong product demand and backwardation are all positive. In our view, the current price environment can persist so long as US producers remain unable to significantly up their investments (notably because of shareholders requiring free cash flow generation). Indeed, if WTI (West Texas Intermediate) futures manage to stay above USD 55 per barrel, there is still a risk that these producers could deploy some of the increased cash flow to accelerate drilling and completion activity, eventually fuelling greater market volatility. 

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