Quarterly Investment Strategy  

21/07/2017

Asset Allocation – Towards an inflexion point in ECB policy

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Is reflation over for good? With US inflation prints having trended down since their February peak, investors are questioning the sustainability of the manufacturing recovery and the so-called “reflationary trade”. Many reasons can be put forward to explain a temporary pull-back: fading base effects on inflation, a tightening of Chinese monetary conditions, the delay in President Trump’s fiscal plan and oil price weakness. But more structural issues that hint to the demise of the Phillip’s curve (low unemployment no longer translates into higher wages because of negative demographics, lesser worker bargaining power, global deleveraging...) continue to feed investor doubts as regards the inflation outlook.

This “goldilocks” economic environment of improving growth and contained inflation has translated into a very favourable mood across financial markets, with most asset classes up over the last quarter. Growing concerns about the outlook for oil prices have, however, recently awakened market volatility from historical lows. For now, given that medium-term oil fundamentals have not deteriorated markedly, we hold to our baseline scenario of prices evolving between USD 45 and 60 per barrel. That said, as the stabilisation of oil prices was a prerequisite for our global scenario and positioning – especially influencing our emerging markets (EM) exposure – we will continue to monitor developments in Libyan and Nigerian production, alongside US shale investment prospects.

Oil risk aside, we think that investor focus is now shifting to central bank activity, with the Fed and ECB policies likely to gradually converge. Eurozone core government bond markets have reached excessively stretched valuations in view of the strengthening economic backdrop. Although a tapering of ECB purchases will affect the sovereign bond universe uniformly, we think that investors’ search for yield will more easily lead them to purchase peripheral bonds than ultra-low yielding core bonds. As such, we maintain our preference for peripherals over core sovereign bonds. With respect to the US Treasury market, we see no reason for the Fed to hike rates more than once more this year. None of the inflation fundamentals (such as the output or unemployment gap, inflation expectations or bank lending dynamics) are pointing to overheating conditions. Headline inflation should even decelerate during the next few months as positive base effects wane.

In the credit space, financial conditions should stay benign, supporting corporates and preventing a surge in corporate defaults. We expect relative spread stability in both in Europe and the US, with a preference nonetheless for US credit which offers a better balance of risk from an all-in yield point of view, mainly as we expect less support from ECB purchase programmes going forward. We believe that the high yield (HY) segment should also benefit from the improved growth outlook, warranting spread stability. It is true that the oil price correction has recently caused spreads to widen in the energy sector but, so far, there has been no contagion to the rest of the HY segment. That said, combined with the tightening of financial conditions in the US, the effect of the gradual reduction in ECB corporate bond purchases does warrant close monitoring and selectivity going forward.

In the currency space, with the climax of the monetary divergence between the Fed and the ECB possibly already behind, we can expect the euro to rebound towards the 1.20 level against the greenback over the next 12 to 18 months. As such, we began to hedge some of our dollar exposure in EUR and CHF portfolios last month. Given the close watch kept by the Swiss National Bank on the ECB, we see it likely to adjust its negative rate policy shortly after the ECB does, so as to maintain the exchange rate broadly within the same range. Despite a slightly more hawkish stance from the Bank of England, the British pound will remain under pressure with domestic activity, notably consumption, clearly in a depressed state. Finally, the Bank of Japan being the last central bank to persist in its accommodative stance, the Japanese yen will continue to suffer.

As political risks abate one after the other, fundamentals are back to centre stage in equity markets. The decent macroeconomic picture and strong earnings season continue to support risk-taking, as evidenced by US indices reaching new highs and volatility at ultra-low levels. As expected, Emmanuel Macron’s win in France drove investors to reassess their European equity underweight: European equity funds are seeing considerable inflows. And while stock market valuations are clearly rich, this situation can persist so long as the earnings dynamics are supportive and interest rates stay contained by historical standards. This is particularly the case in Europe, where economic growth and, in turn, company earnings expectations continue to be revised up. Bottom-up factors, such as mergers and acquisitions (M&A) activity, are likely to fuel another leg of the rally. Admittedly, the currency appreciation that should go with improved European macroeconomic momentum might eventually dampen some companies’ earnings prospects. We thus advise a portfolio positioning that favours domestic themes (banks, small caps) as well as industrial sectors exposed to emerging markets (themselves in recovery and currency appreciation mode).

Finally, we maintain our strategic overweight of emerging markets given low valuations levels, improved earnings dynamics and the early stage of their economic recovery cycle. We also 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. And, interestingly, while commodity volatility must obviously be monitored, it has so far had limited impact on emerging markets.

What is the downside risk to our oil price scenario?
Following a series of negative news, oil prices are evolving at the lower end of our anticipated USD 45-60 per barrel range. More information would, however, be required for us to change our outlook.

Indeed, fundamentals remain well-oriented, with the oil market in deficit since the start of the year (after almost three years of oversupply). This is mainly the result of the OPEC1 agreement, which targets prices just below US shale companies’ marginal costs so as to restrain their investments and future production. The firm commitment of all OPEC members to respect their quotas keeps us optimistic. While recent data points do show increasing production in Nigeria and Libya, these two OPEC members were initially exempted from the deal. Should these trends persist, we would expect OPEC to take measures to ensure the efficiency of its agreement.

Another market concern relates to US production. After several months of declining inventories, some mixed figures in the US fuelled market volatility of late. The period of oil prices above USD 55 per barrel witnessed earlier this year stimulated more investments than expected. Conversely, though, the currently depressed market environment should lead to cuts in capital expenditure in months to come.

Given the currently very bearish market sentiment, a downward trend in US inventory data and/or OPEC action to address Nigerian and Libyan production would be supportive to the oil price. Seasonality should help on the inventory front (driving season in the US and power burn in the Gulf countries), while we expect OPEC to effectively do “whatever it takes” to ensure the efficiency of its agreement.

European M&A: back in action?
After a fairly subdued 2015-2016 period, European M&A volumes have strengthened markedly year-to-date, bringing the thematic back to centre stage. In the first six months of this year, the value of M&A transactions rose 13% year-on-year in Europe, versus a 19% decline in the US. And European targets represented 37% of global M&A, up from 33% for the same period last year.

What are the reasons behind this M&A revival? For a start, financing conditions in Europe are very favourable with ample liquidity provided by the ECB, good credit impulse from commercial banks, a near 10-year low cost of debt for European corporates and cash-rich balance sheets. But while this is a necessary condition, it had already been in place for several quarters. Why then is M&A really picking up now? We see business confidence as the major element that had been missing on this side of the Atlantic. Despite fairly robust economic data and low market volatility, uncertainty surrounding the future of the single market certainly dampened management enthusiasm. Following Emmanuel Macron’ election, optimism as regards deregulation and more generally a pro-business environment provide the perfect background to initiate major operations. Going forward, given that the US and Europe are at different stages of the credit cycle, there is some room for European M&A activity to catch up.

Market impacts are twofold. First, with investors nervous about valuations at the index level, M&A could serve as another catalyst for the equity rally, generating value while also increasing the stock-picking opportunity set. Second, from a cross-asset standpoint, M&A traditionally calls for a preference for equity markets over credit markets. Indeed, when operations are financed by debt issuance, the resulting impact on the balance sheet favours the shareholder over the bondholder. Corporate bonds of acquiring companies are likely to be more volatile as their creditworthiness deteriorates. Conversely, expectations of improved earnings on the back of synergies and expanded market share are likely to support inflows on the equity side.

Rising M&A activity thus offers another justification for maintaining our risk-on strategy, via an overweight of European equities, while keeping a prudent and selective stance on credit.


1Organization of Petroleum Exporting Countries.

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