Coffee Break 12/17/2018

LAST WEEK IN A NUTSHELL

  • At the end of Theresa May’s most difficult week in office, the United Kingdom still proves incapable to leave (or stay in) the EU.
  • France’s difficulties in implementing reforms were highlighted by on-going social unrest in spite of the government’s willingness to increase spending towards a 3.4% deficit/GDP ratio.
  • In the US, consumer price inflation rose to 2.2%, its slowest pace in 9 months as fuel and energy costs fell.
  • Chinese consumer and manufacturing data came out softer than expected. Local authorities also announced that they would lift retaliatory tariffs on US cars for 3 months, starting January 1st.
  • The European Central Bank confirmed the end of its QE programme as of 31 December 2018 and will keep reinvesting cash from maturing bonds for an extended period of time.

WHAT’S NEXT?

  • A week of more Central Banks meetings and confidence data publications is coming up.
  • The outcome of the FOMC policy meeting and Jerome Powell’s press conference will take place on Wednesday. Markets expect a 25bp hike in the funds rate with a probability of 80%.
  • The Bank of Japan and the Bank of England monetary policy meetings will take place on Thursday.
  • A partial US government shutdown could start on Friday as President Trump and congressional Democrats cannot agree on border security measures.

INVESTMENT CONVICTIONS

  • Core scenario
    • In the US, we expect growth to be close to 3% in 2018, and to slow down in 2019 due to fading fiscal stimulus, trade policy uncertainties and tightening financial conditions as the Fed maintains its rates normalisation.
    • Outside the US, the economic cycle is less dynamic and hitting a plateau. European momentum is disappointing and policy risks remain.
    • As the US-China relationship appears fractured, China is easing in the face of a slowdown (monetary, fiscal, and currency).
    • The decline in the price of oil should pause the gradual rise in inflation in the US and in the euro zone.
  • Market views
    • US economy remains strong, and does not reveal any economic imbalances. The Fed is however appearing less hawkish and more data dependent.
    • Above-potential growth, the tax reform, buybacks and no valuation excess vs. bonds keep pushing US equities up over the medium term.
    • Based on fundamentals, we see potential for a narrowing divergence between the US and the rest of the world. The various political risks are a headwind.
  • Risks
    • Trade war: The US and China bought three months of time to resolve the structural issues. In the meantime, higher tariffs and protectionism are slowing down global economies, deteriorate international relations and ultimately corporate margins.
    • Emerging markets slowdown: Emerging markets are among the most vulnerable regions when global growth slows down. The evolution of the USD liquidity is also key for the region due to outstanding debt in this currency.
    • EU political risks: Political pitfalls could fuel euro scepticism further as opinions diverge on a growing number of issues, i.e. “Brexit”, Italian budget, social unrest in France and trade negotiation outcome with the US.
    • Domestic US politics: Democrats could slow down Donald Trump’s legislative agenda. Passing legislation will be a result of compromises and “beautiful deals”.

 

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

We remain tactically overweight equities. From a regional perspective, we remain overweight US and euro zone equities. We continue to hold a negative view on the UK, due to the unresolved “Brexit” issues, while being neutral emerging markets and Japan. In the bond part, we keep a short duration and a cautious view on Italy. Our fixed income preference goes to Emerging markets.

 

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We have kept our equity exposure overweight and still have a constructive medium-term view based on fundamentals. 
    • We are overweight US equities. Economic momentum stays decent although the fiscal stimulus boost is fading. We expect slower, but positive, earnings growth in 2019. Fed hiking is a headwind but the slowdown underway could moderate the Fed’s hawkishness as it is “data dependent”.
    • We remain overweight euro zone equities. Slow growth and political uncertainties are increasingly weighing on the stock market. Conversely, any conflict resolution is a potential trigger for a strong rebound.
    • We remain underweight Europe ex-EMU equities. The region has a lower expected earnings growth and thus lower expected returns than the continent, justifying our negative stance.
    • We are neutral Japanese equities. Japanese stocks reflect less domestic risk as “Abenomics” will continue for three more years. The cyclical economic momentum is becoming less favourable.
    • We are tactically neutral emerging markets equities. While we believe in the growth of Emerging markets, they are badly hit by the trade war, the developed markets’ slowing growth and the USD strength. 
  • We are underweight bonds and keep a short duration
    • We expect rates and bond yields to keep rising gradually. In addition to rising producer prices, rising wages, fiscal stimulus and trade tariffs could push inflation higher.
    • The expanding European economy could also lead EMU yields higher over the medium term. We expect interest rates to gradually increase. We remain underweight Italian bonds. The ECB remains accommodative, but has confirmed that it will end its QE in December.
    • We have a neutral view on corporate bonds overall as there is little spread compensation for risk. A potential increase in bond yields could hurt performance.
    • Emerging market debt faces headwinds with trade war rhetoric and rising US rates, but we believe spreads can tighten from current levels. The carry is among the highest in the fixed income universe. It represents an attractive diversification vs other asset classes.