06 JUL

2017

Asset Allocation , Topics

Looking for stability

Given our confidence in the sustainability of positive global growth and more hawkish central banks throughout the next quarters, Candriam remains strategically overweight equities and keeps an underweight and short duration on fixed-income for H2 2017. We expect above-trend growth during H2 2017 to lead to sustained global profit growth. Our strongest regional conviction is to overweight Eurozone equities which benefit from positive tailwinds as growth drivers are now well in place leading to broader expansion throughout the region and the prospect of EU disintegration has sharply diminished, boosting confidence. On the other side of the Atlantic, growth should continue at a moderate pace but the new US administration has so far not been able to leverage the political alignment between the President and Congress.

There remain both upside and downside risks to our asset allocation outlook. Among downside risks we identify a monetary policy error (i.e. tightening too far, too quickly) from either the Fed or the ECB could derail current expansion. A surprise downturn following Chinese stop-and-go policies would negatively impact commodity markets. A breakdown of the Brexit negotiations represents a specific risk for Europe. On the other hand, upside risk includes acceleration in the European integration agenda, or a smooth and timely implementation of US fiscal stimulus, tax cuts and regulatory easing measures.

Stars are aligned for the Eurozone

Investors have started to re-discover the Eurozone as political risk has switched from Europe to the US. The French elections coincided with the start of a sharp decline in the political risk premium on European equities. We think that we are past the peak of EMU policy uncertainty, as the Italian risk on the horizon appears manageable and could be cleared sooner than expected this year. Clearly, the integrity of the Eurozone appears no longer at risk for the time being. Moreover, European leaders could embrace stronger European integration. Building a roadmap including strengthening of the single market, the financial sector and crisis-response, complemented with an enforcement of external borders and an investment stimulus, would lead to new dynamics in the EU.

By now, the Eurozone recovery is well on track and should lead to above-trend growth in 2017-18. This has led us to raise our profit forecasts for Eurozone equities, in which we are overweight. The region is recovering after three deflationary shocks: the financial crisis in 2008, the sovereign crisis of 2011 and the commodity shock of 2014-15. Several tailwinds are now at work:

  • the European corporate sector is enjoying upward earnings revisions for the first time since the crisis. The perspective of rising profits (double digit growth) implies an attractive valuation in absolute and, more importantly for non-resident investors, in relative terms (15x on a 12-month forward basis vs. 18x for the US market);
  • investor positioning has just started to move towards European equities. The electoral shocks of 2016 and the associated rise in the political risk premium led to substantial outflows last year. It would take more than EUR80bn of inflow just to reverse last year’s drain. We expect this to happen over the coming months;
  • as we expect the main ECB refinancing rate to remain at present levels for an extended period of time, while the purchasing programme is likely to be reduced in terms of size (tapering), the yield curve could steepen. ECB tapering announcements should become a central theme during the summer, in line with economic robustness in the region. The improvement in the European economy could also lead EMU yields higher, as political risks recede.

Among equities, domestic stocks, small and mid-caps, financials, cyclicals and value stocks would be the main beneficiaries. We expect the Eurozone stock market to yield a return of more than 10% over the next 12 months.

Regarding the start of the Brexit negotiations, Candriam expects that, ultimately, the economic loss for the UK will be significantly higher than for the remaining EU-27. This leads us to an underweight stance on Europe ex-EMU equities. This implies a deterioration in domestic economic conditions, reflected in a further downturn in GBP and weaker domestic equities (cautious on the FTSE 250).

No excess in the US

Global expansion dynamics have become less uniform than at the turn of the year, but remain supportive. The US cyclical expansion stalled in Q1 and activity data has yet to catch up with survey optimism, which led us to reduce our US equity exposure to neutral. We expect the US economy to recover the lost ground over the course of the year.

At current valuations of 18x forward earnings, US markets appear to be the most expensive region, based on single-digit profit growth.

The lack of political success in Congress, including the critical reception of the FY 2018 budget request, and the escalation of sensitive issues have questioned the credibility of the new administration. Progress on healthcare reform could put the tax reform on the agenda, a welcome issue to improve the credibility of the Trump presidency. Slippage in the timing of the healthcare reform and the fiscal stimulus appears to be a source of uncertainty.

To become more constructive on the US, we would need to see more clarity both domestically on US reflation, through fiscal stimulus, tax cuts and regulatory easing, and internationally, on geopolitical tensions with Syria, North Korea and Iran. A swift implementation of fiscal measures, no further domestic hiccups and geopolitical appeasement would represent upside risks to our outlook.

As a result, we expect upward pressure on US bond yields to be less intense than in the immediate aftermath of the Presidential election. Nevertheless, the upward pressure should prevail as Fed hikes, combined with positive tailwinds from activity, and a tight labour market should push the 10y Treasury bond yield towards 2.90% by mid-2018. Credit markets will ultimately be negatively impacted by rising yields, while both IG and HY spreads have little further tightening potential from current levels.

The collateral victim of the current policy of the new administration and the re-discovery of Europe is the US dollar as it lost more than 5% in its value on a trade-weighted basis. A material change in the monetary policy stance of the Federal Reserve towards a more hawkish bias would likely lead to a stronger USD. There is a risk that new nominations to the Board of the Federal Reserve could lean in that direction, but there has been little progress made so far to fill in the vacant positions.

Emerging Markets: manageable risks

As we expect dovishness to morph into a more neutral stance among leading developed market central banks, emerging market assets reveal additional upside potential. Tightening in developed markets is at odds with expected monetary policy easing in emerging markets. In addition, EM bonds benefit from a weaker USD and strong fundamentals. We indeed believe that emerging market debt is still attractive to fixed income alternatives and Candriam’s overall assessment of emerging market debt has not changed dramatically despite the renewed rise in Brazilian political risks. In particular in Brazil, monetary policy easing by the Central Bank should prevail, given the strong disinflation trend. We are also keeping a positive view on the local duration, in South Africa, Mexico, Indonesia and Brazil.

We still have a positive view on EM forex, split between low beta EM Asia (Indonesia and Malaysia) and Central and Eastern European currencies that should benefit from the rebound in European growth and the strengthening EURUSD exchange rate..

We have an overweight stance on emerging market equities. They benefit from attractive valuations (12x one-year forward earnings) in a robust global growth context. As a result, corporate profits in emerging markets should improve by more than 10% over the coming year.

China should not trigger a systemic risk this year, but we are keeping an eye on the impact of regulatory tightening which has accelerated somewhat this spring. An important milestone for the coming quarters will be the 19th National Congress of the Communist Party of China in the autumn as it will likely focus on leadership transition.

Japanese assets supported by the BoJ

The Bank of Japan will most likely be the last to retract its massive support for the economy. Since 2013, its balance sheet has increased by JPY340tn to reach JPY500tn. Ample liquidity injections from the Bank of Japan (BoJ) will continue at uninterrupted pace. Unlike the Federal Reserve or the ECB, there is no end in sight for BoJ balance sheet expansion. Ultimately, this should weaken the currency. This is important as Japan’s relative equity performance remains highly correlated (-70%) to its currency, as it is geared towards export performance and Japanese earnings benefit from a weak Yen.

Favourable conditions support the Japanese economy. A supportive policy mix, a tight labour market, an improvement in profit margins and corporate pricing power are currently at work. In addition, global growth is now a more significant determinant of Japan's corporate sales and profits than domestic GDP growth, as overseas sales account for 58% of total revenue. With a PE 12 month forward slightly below 14x, we think that Japanese equities are currently fairly valued. The next step, an overweighting of Japanese equities, would make sense if global growth continues to accelerate, which could lead to a resumption of the reflation trade, implying a stronger USD and rising bond yields.

Downside risks are mainly limited to an unanticipated change in the central banks’ stance as this would likely impact the JPY.