15 FEB

2017

Asset Allocation, Topics

Global growth expanding in a synchronised way

Executive Summary

  • Global growth is expanding in a synchronised way. Activity indicators continue to accelerate, with the exception of the UK.
  • Central bank stimulus is still significant, except in the US. Markets are pricing-in two Fed hikes in 2017 and another two in 2018, all four below the median Fed projection.
  • We are mantaining our cautious positioning in UK equities and short position on the GBP against the EUR, as we believe the negative impact of Brexit is not yet fully reflected.
  • We remain overweight equities via the US, the Eurozone and Japan .
  • We have recently increased our position on emerging markets. The USD remains broadly stable and the region appears to be less vulnerable than in the immediate aftermath of the US elections. Also, an outright trade war between China and the US seems less likely for the time being.

CROSS-ASSET STRATEGY

Global growth expanding in a synchronised way 

United States: accelerating activity amid a foggy outlook

Activity indicators – combined with GDP growth estimated at 1.9% in Q4 – continue to point to further acceleration, and are supported by solid consumption and a lesser drag from corporate spending. Consumer confidence remains very high while the labour market has continued to improve despite the recent slowdown in average hourly earnings. However, with the economy close to full employment, wages should, at some point, accelerate further and support the rise in inflation. Given the moderate wage growth, the Fed is in no hurry to hike and will adjust the pace of its tightening to any change in financial conditions and the intensity of the fiscal stimulus. The corporate tax reform promised by Donald Trump could take longer to finalise as the budget resolution must be agreed to by the House of Representatives, the Senate and the Office of Management and Budget. As a result, our GDP forecasts for the United States now stand at 2.4% for 2017 and 2.6% for 2018, assuming a moderate pace and magnitude for the coming policy stimulus.

Euro zone: resilient-to-lasting political uncertainty

Recent surveys point to some acceleration in activity, with a still-improving economic sentiment and stronger PMI indices. Business confidence remains high, although the German Ifo index weakened somewhat in January. Meanwhile, consumption – supported by an improving labour market – should remain well oriented. Furthermore, the higher oil price is expected to push inflation towards 1.5% on average in 2017, while core inflation remains subdued. Exports should continue to progress at a moderate pace thanks to a lower euro. Separately, the ECB should remain accommodative, given the lingering political risk and rising bond yields.

In this context, we have revised upwards our GDP forecasts in the euro area to 1.6% for 2017 and 2018.

Central banks are decoupling

The expected monetary policy gap between the US and the rest of the world is likely to increase in the coming months. The Federal Reserve tightening cycle is ongoing, while monetary policies in Japan, the Eurozone and, to a lesser extent, the UK, remain highly accommodative.

  • The FED increased its rates by 25bps in December and forecast three interest rate hikes for 2017. Furthermore, the reinvestment of maturing bonds is likely to be questioned in the coming quarters, as Janet Yellen has started to address the issue.
  • The Bank of England remains supportive.
  • The Bank of Japan upgraded its GDP outlook on 31 January 31, but has kept its stimulus unchanged, leaving its target on 10-year Japanese government bond yields around zero.
  • The ECB will extend its asset purchase programme beyond March 2017 for nine months until the end of December 2017. However, asset purchases will be reduced from €80 billion to €60 billion per month starting from April.

 

Corporate tax reform in the United States: what is at stake?

The corporate tax reform has been identified by both the President and Congress as a top priority of the new US administration. Possible features of the planned corporate tax overhaul include:

  • a reduction in the federal tax rate from 35% to 20%;
  • businesses being allowed to depreciate capital expenditures in one year rather than over many years, but no longer being allowed to deduct interest expenses. However, there are the still unresolved questions of what the rules will be on interest deductibility for banks;
  • the introduction of a border tax adjustment: for each company, only domestic sales and expenses will be taken into account to calculate the income tax base. Unless the dollar appreciates significantly, this would be favourable to exporters and unfavourable to importers. Potential winners would be companies operating in local manufacturing bases with a significant proportion of the relevant costs in the US.
  • Moreover, proponents of the plan anticipate a rise in the dollar and this would penalise dollar debtors and destabilise some emerging economies. Separately, the tax reform is likely to be seen by other countries and the World Trade Organisation as a protectionist act that violates US treaty obligations.

 

Cross-asset: overweight in equities

The global context remains supportive to equities. Despite their slight increase in the Eurozone, risk aversion measures remain at a low level and are supportive of equity market performances. The BofA Merril Lynch Fund Manager survey shows that positions in equities have risen to a 13-month high while allocation to bonds has fallen to a 13-month low.

In terms of asset allocation, risk appears to have switched from equities to bonds, as the prospect of a US recession in the next 12 months has sharply diminished. Furthermore, equities have an attractive relative valuation compared to credit, and their expected return should be boosted by encouraging Q4 earnings results so far. Meanwhile, we continue to monitor the main political events that could create uncertainty and volatility on the equity markets.

REGIONAL EQUITY STRATEGY

Constructive on US and Japanese equities

  • We are still positive on US equities. We expect stronger growth and a rise in corporate earnings, especially under President Trump’s spending policy. The earnings recession is now clearly behind us and should reach double-digit figures. Valuations are high, so earnings growth is crucial for US equity market performance. We remain positive on Japan. The country is benefiting from improving activity indicators, a supportive domestic policy mix and relatively attractive valuations. The yen has stopped decreasing against the US Dollar, but remains attractive at current levels. The correlation between the Nikkei and the Yen remains very high as currency depreciation is a synonym of upward earnings revisions.

 

Slightly overweight on euro-zone equities and negative on the UK

We still believe in the possible re-rating of euro-zone equities driven by an attractive valuation, an increase in corporate profits and a positive investor sentiment that is nonetheless less bullish than last month.

  • political uncertainty: a retreat towards the median EU uncertainty level since 2011 would help further euro-zone outperformance;
  • economic momentum: despite their recent decline, economic surprises remain very high;
  • earnings growth: earnings revisions are improving, benefiting from stronger domestic and external demand. 

However, uncertainty could resurface when the Brexit negotiations start, and the road ahead is paved with political risks galore. This justifies our slight overweight on euro-zone equities, and ongoing negative stance on UK equities:

  • he UK government acknowledged the strongly negative impact of Brexit on revenues. In addition, the deterioration in domestic UK macro indicators should hit the FTSE 250 with significant domestic exposure. In particular, we are avoiding domestically oriented small- and mid-caps;
  • the relative valuation is rather expensive, as earnings have dropped in recent years.

Relative to the US, Euro equity performance continues to recover some ground.

A new positive on Emerging Markets

We have recently increased our position on emerging markets. The USD remains broadly stable and the region appears to be less vulnerable than in the immediate aftermath of the US elections. Also, an outright trade war between China and the US seems less likely for the time being. India remains our preferred emerging market, thanks to:

  • improving fundamentals, with 7.1% GDP growth and receding inflation expected in 2017;
  • an improving current account that makes India less vulnerable to external influences – a major theme since Donald Trump’s election and possible protectionist measures;
  • a supportive domestic reform agenda in the long run despite one that is currently penalised by bank note issues.

FIXED INCOME STRATEGY

Diversification out of low-yielding bond segments

Since Donald Trump’s election, we have maintained our strong conviction on a longer-term rise in US bond yields. We have further increased our underweight in duration. We continue to favour a short on US Treasuries.

  • We have kept our slight overweight on high yield. The significant spread-tightening has reduced the potential, but the carry remains attractive.
  • We have a slight overweight in emerging debt,  both in local and in hard currency. Emerging debt spreads have reached our target, but are still attractive against US Treasuries. Nevertheless, we remain cautious, as a stronger USD and higher US yields would imply downward pressure on currencies.
  • We remain positive on inflation-linked bonds:
  • We expect an increase in the observed and expected inflation due to a sustained rise as a result of US fiscal easing, rising wages and receding Chinese deflationary pressures.
  • Oil-price base effects represent the main inflation increase driver for Q1 2017.

COMMODITIES STRATEGY

Commodities – boosted by the continued rebound of materials – continued to recover in January, in line with the global cyclical expansion. Copper prices have jumped over the past month, on the back of Chinese inflation growth. Brent crude oil remained more or less flat, around 55 USD/barrel while OPEC members cut production levels in January, towards the 32.5 mbd agreed. However, US rigs have been re-opening, implying a greater production that is likely to weigh on oil prices. Moreover, the panoply of executive actions from Donald Trump on energy issues, such as the Dakota access pipeline, could also put some pressure on oil.

Separately, gold edged higher as the US dollar lost ground in the first month of the year and US interest rates remained more or less stable.