Coffee Break 19/11/2018

LAST WEEK IN A NUTSHELL

  • Italy submitted the same draft of its 2019 budget to the EU although it had already been rejected once for breaching EU rules, worrying investors and pushing bond yields higher.
  • Several ministers of the UK’s government have resigned following the completion of the “Brexit” draft agreement. The political uncertainty will persist.
  • The oil market is showing tentative signs of stabilisation as producers are expected to announce an output reduction at the next OPEC meeting in Vienna in December.
  • On the data front, inflation and Q3 GDP growth figures in key countries confirmed a slowing expansion cycle with slowly rising inflation in Europe, the US, Japan and China.

WHAT’S NEXT?

  • Purchasing Manager Indexes are due in key countries, including the US and the euro zone. They will shed some light on the momentum of the activity cycle.
  • The European Commission will shortly publish its opinions on the budget plans of its members, another opportunity to turn the spotlight on Italy, with markets reflecting the relative hopelessness of the situation (a lose/lose situation for the EU).
  • The US will celebrate Thanksgiving on Thursday. The Friday after, also known as “Black Friday”, is the start of the Christmas shopping season for retailers.   

INVESTMENT CONVICTIONS

  • Core scenario
    • In the US, we expect growth to be close to 3% in 2018, and to slow down in 2019 to 2.6% due to fading fiscal stimulus, trade policy uncertainty and tightening financial conditions as the Fed maintains its rates normalisation.
    • Outside the US, the economic cycle is less dynamic. 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). It is worth remembering that China would also have to agree to any trade deal, and has the capacity to hold out against current sanctions.
    • Gradual rise in inflation in the US and in the euro zone, but no inflation fear.
  • Market views
    • US economy remains strong, and does not reveal any economic imbalances.
    • 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: higher tariffs and protectionism could slow down global economies more than expected, deteriorate international relations and ultimately corporate margins. G20 summit end-November could be a catalyst.
    • 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, German leadership reshuffle, 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.

 

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We have tactically kept our equity exposure overweight and still have a constructive medium-term view based on fundamentals. 

    • We are overweight US equities. Economic momentum is boosted by fiscal stimulus but fading. There is strong earnings growth –witness the Q3 reporting season- and valuations are around historical levels.
    • We remain overweight euro zone equities. Slow growth and political uncertainties are increasingly weighing on the stock market. However, 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 positive economic momentum encouraged us to become neutral on the asset class.
    • 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
    • With a tightening Fed and expected upcoming inflation pressures, we expect rates and bond yields to keep rising. 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 with a 12-month target of 0.90% for the German 10Y yield. 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.