In the US, cyclical expansion hit a soft patch, leading to our neutral stance on US equities, while recent data confirmed that the European recovery is well on track and leading to above-trend growth in 2017-18. As a result, we increased our earnings expectations for Eurozone equities, one of our strongest convictions. We agree with Mario Draghi that deflationary forces, registered until last year, are no longer present, though global inflation momentum is only rising gradually. Meanwhile, protectionism fears have decreased (China, NAFTA), but have not completely disappeared, as demonstrated by the G20 summit. Against this backdrop, we are slightly overweight on equities and have strong regional convictions, favouring an allocation to EMU, Japanese and emerging market equities, while keeping a short duration bias.
We think that we are past the peak of EMU policy uncertainty following the elections in France, with Italian risk looking manageable on a medium-term horizon and already priced-in by markets. In the US, lack of progress on healthcare reform in Congress has called tax reform plans in question, a cornerstone for the credibility of the Trump presidency. Slippage in the timing of the fiscal stimulus continues to be a source of uncertainty. We are waiting for more clarity to become more constructive: domestically, on US reflation through fiscal stimulus, tax cuts and regulatory easing; internationally, on geopolitical tensions with Syria, Iran and North Korea.
We expect another Fed hike later this year, which is not priced in by the market. The next step in the Fed tightening process will be through balance sheet reduction, the timing of which is uncertain but is likely in September. Similarly, ECB tapering announcements have become a central theme after Mario Draghi’s latest speeches, in line with economic robustness in the region. Tightening there is at odds with a highly accommodative Bank of Japan (BoJ) and monetary policy easing in emerging markets, including Brazil.
GENERAL OVERVIEW: Equities vs. Bonds
The global economic environment remains supportive for equities versus bonds from a medium-term perspective. The expansion continues and the Eurozone has clearly taken the lead with robust and improving economic indicators. The soft patch, observed since February/March in the US, appeared to come to an end as the first half drew to close. Central bankers around the world -with the notable exception of the BoJ - have acknowledged that economic news is firming. This can also be seen in the turnaround in economic surprises for the US, a mean-reverting series by construction, which bottomed out at the end of June. We expect the upcoming expansion to be the second step in global reflation, which started last year with a global recovery. In the meantime, central bank dovishness is gradually receding.
The key question for the coming months is the resilience of equity markets to the –gradual– tightening bias. Uncertainty about how much inflation will respond to tightening labour and goods markets favours this gradual approach. Since the equity rotation is following bond market signals, we increased our exposure to Japanese equities, further expanding our exposure to an investment theme geared to the cycle and benefiting from an ultra-accommodative central bank.
REGIONAL EQUITY STRATEGY
Slightly overweight on equities
We have a neutral stance on US equities. US stock markets have benefited from post-election optimism among consumers and businesses, but activity has been in a soft patch. Now, economic newsflow is starting to become more supportive again in the US. Economic surprises have started to recover from extreme negative levels. Even so, we still see some execution risk in the announced fiscal stimulus and will closely follow updates from lawmakers. Failure on the healthcare reform would not be helpful in restoring confidence
FIXED INCOME STRATEGY
Negative on government bonds, short duration
US oil production is recovering, whereas global production remains high. As a result, the price of oil (Brent) is struggling to top the USD50/bbl threshold. Technically speaking, USD44 and USD42 represent important support levels.