Quarterly Investment Strategy  

18/05/2017

Asset Allocation – Keep looking on the bright side

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The reflationary economic environment continued to prevail during the 1st quarter of 2017. The Trump administration’s protectionist rhetoric did not materialize and the European political picture will soon become clearer, with the French presidential election only weeks away. As the saying goes, financial markets climbed a wall of worry: emerging assets outperformed their developed peers, the greenback weakened and European equities did better than US indices. What does the 2nd quarter hold in store?
 

The reflationary economic environment continued to prevail during the 1st quarter of 2017. The Trump administration’s protectionist rhetoric did not materialize and the European political picture will soon become clearer, with the French presidential election only weeks away. As the saying goes, financial markets climbed a wall of worry: emerging assets outperformed their developed peers, the greenback weakened and European equities did better than US indices. What does the 2nd quarter hold in store?

Fundamentals continue to be supportive of risk taking. The cyclical manufacturing recovery is gaining strength and the corporate earnings upturn has broadened, with positive revisions in almost every region and sector. Once European electoral fears fade, the political risk premium will recede, benefiting European assets. First signs of the ECB reconsidering its non-conventional monetary policies could also be an important development. Although the central bank has pledged to maintain its asset purchases at EUR 60 billion per month until the end of 2017, it could – given the gradual normalisation of inflation expectations – start to consider an exit strategy from negative interest rates by early 2018. In turn, we can expect a progressive recovery in the single currency, a positive reaction of European bank stocks and a tightening of spreads between peripheral and core European government bonds.

In the US, the market will closely track the ability of the new administration to push through promised reforms, notably a corporate tax cut and a cash repatriation incentive. Any delay in their implementation will constrain the Fed’s room for action. We continue to expect only one or two further rate hikes this year, limiting US dollar appreciation, particularly against the euro (assuming Marine Le Pen is not elected French President).

On equities, the current US market valuation calls for some caution. At over 18x 2017 expected earnings, much of the support from corporate tax cuts has already been discounted, making any delays or lesser-than-expected reform a risk. By contrast, European markets are trading at 15x 2017 earnings, reflecting the political risk and related caution on the part of international investors. A win for Emmanuel Macron in France (by far the most probable scenario) will push investors to reassess their underweight in European equities. Within Europe, we recommend the Eurozone and Switzerland, rather than the UK. Sector-wise, European banks could benefit from political relief as well as an inflexion in ECB non-conventional measures. We maintain our strategic overweight of emerging markets given low valuations levels, improved earnings dynamics and the early stage of their economic recovery cycle.

As regards fixed income, as mentioned above, we see no reason for the Fed to tighten more than a couple more times this year. None of the inflation fundamentals (such as the output or unemployment gap, inflation expectations or bank lending dynamics) seem to be pointing to overheating conditions. Headline inflation should even decelerate during the next few months as positive base effects wane. With most of the normalisation of inflation expectations already priced-in on long maturities, we thus maintain our expectation of a flatter US yield curve. In Europe, on the other hand, the progressive normalisation of inflation expectations combined with a dovish tapering of the ECB’s quantitative easing programme from April 2017 argues for a bear steepening of the yield curve, especially in Germany. That said, the sharp rise of long-term yields in the periphery seems overdone and starts to offer relative value compared to the German bund – provided no anti-European Union party gains power in Europe. This eventuality has already been avoided in the Netherlands where Wilders’ Party for Freedom came second in the parliamentary elections. All told, we maintain our underweight stance on developed market sovereign bonds.

In the credit space, despite elevated leverage, the coverage of interest expenses should remain sufficient to avoid a surge in corporate defaults and recessionary risks are being postponed to 2018 or beyond. We expect relative stability in credit spreads both in Europe and the US. The high yield segment should also benefit from an improved growth outlook, although we must acknowledge that most of the spread narrowing has already taken place. Warranting close watch going forward are the pace of financial conditions tightening in the US and the effect of the gradual reduction in ECB corporate bond purchases – neither risk being imminent.

We continue to favour emerging market local currency debt. Beyond the attractive carry, we feel comfortable with the long-term prospects for currencies that depreciated heavily during the last few years. And while the risk of US protectionist measures must obviously be monitored, it has so far not proved damaging.

Oil prices fell in March, after trading in a tight range during the early weeks of 2017. Oversupply concerns led to the unwinding of record speculative positions on higher crude prices, built up in the aftermath of the OPEC1  agreement to cut production late last year. With OPEC members having shown discipline in reducing their output, we continue to expect a rebalancing of oil supply and demand during the 2nd quarter of 2017. The oil market should thus be in deficit shortly, requiring refineries to draw down inventories and supporting the oil price over the next few months. For the full year, we still expect an average price of USD 60 per barrel. That said, the emergence of US shale industry caps the upside potential. 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. Elsewhere in the commodity sector, base metal prices are supported by the rebound in the manufacturing environment and the stabilization of Chinese economic growth. Sentiment has improved markedly and investors who had neglected these markets for several years seem to be rediscovering their inflation-hedging ability. Finally, we maintain our neutral stance on gold (USD 1,100-1,300 per ounce range): fundamentals are still negative (with production costs well below the current price) but renewed financial demand cannot be excluded once yields stabilise.

Turning to the currency space, the fortunes of the euro will hinge on political developments, particularly the French presidential/parliamentary elections in May/June. We do not see the ECB taking any action until those risks have abated. A euro relief rally can be expected after the elections provided Marine Le Pen is not in power. But for a sustainably weaker dollar trend to materialise, we would need some form of convergence in monetary policy. For the time being, the continuation of ECB asset purchases, even at a slightly reduced pace, should keep the euro at weak levels relative to the greenback. Later in 2017, or early next year, the prospect of the ECB changing its tone regarding negative interest rates and embarking on a long monetary normalisation journey could change the dynamics of the US dollar. Meanwhile, the Japanese yen could suffer further from the yield divergence versus its peers and the British pound remain under pressure as the terms of the divorce with the EU are negotiated.

1Organization of Petroleum Exporting Countries.

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