17 SEP

2019

Unsurprisingly, the US-China trade war is leaving many casualties in its path and has triggered collateral damage, including in the US, in the manufacturing sector, which is slowing down as well. At the same time, we perceive windows of opportunities in the euro zone and among emerging markets and have implemented changes in our allocation. 

Equities vs bonds

While some bonds have performed very well this year in a context of trade war and threatening tweets, we favour equities - once again. 

Our strategic longer-term view remains moderately positive. Our central economic scenario relies on:

  • The absence of an impending recession.We believe recession fears in the US are exaggerated. 
  • Central banks renewing monetary easing, mainly in the US and in the European Union.

From a tactical shorter-term view, we are overweight equities via the US – the safer region – but also the euro zone since our most recent investment decisions. 

There is no doubt that the macroeconomic context is being challenged and that it does not currently offer much support. However, economic surprises are improving. Central banks are increasingly supportive. While the US and China are in the eye of the hurricane with the ongoing trade war, the euro zone is enjoying a period of decreasing political instability compared to the beginning of the summer. 

Valuations are supportive for equities vs bonds. The drop in bond yields over the past 4 weeks with the Bund touching -0.71% is also a key support factor for equities on a relative basis.

US equities remain our main conviction

We remain US equity overweight

The trade war is slowly hitting home: the US manufacturing ISM is now below the 50 threshold. 

There is a downturn in sentiment among households and manufacturing companies, especially if they export, and among also investors. 

However, as a result of the uncertainty-led slowdown, the Fed is expected by the market - and by President Trump - to continue cutting rates. 

The graph shows the market’s expectations of the Fed’s funds forward rate expected 1-year and 2-year ahead, as well as the target rate midpoint.  

The (negative) forward spread continues to indicate expected rate cuts in the near term and over the next 2 years: 95bp rate cuts in the coming year and an additional 25bp beyond this date.

Hence, while we are aware that the US economy is slowing down, the US equity market still benefits from the protection of President Trump and the Fed. 

In terms of performance, the US equity market is still ahead but earnings growth is at stake and the country will soon need to close a trade deal with China. With an election year coming up, Trump will probably do his best to secure re-election.

 

Emerging markets: A laggard with the potential to catch up 

Emerging markets have suffered so far this year but they also have the potential to rebound:

  • A trade deal will eventually be signed. At least, negotiations have recently resumed and China turned the other cheek by not retaliating right after the latest tariffs imposed by the US. 
  • The main scenario still includes GDP growth of +6% in 2019. The market has underperformed the most this year but China, in our central scenario, should still be able to deliver at least 6% in economic growth. 

In addition, the equity valuation is relatively attractive compared to other regions: with earnings being revised downward, valuation is now close enough to its historical median. 

Since our previous investment decisions, we added slightly to our exposure to the region but still remain neutral emerging markets. We will keep the region under close monitoring. We would reconsider our positioning and add exposure to the region on condition that:

  • A trade deal, even partial, is agreed; 

Or, 

  • The region stages an economic turnaround 

Euro zone: A window of opportunity has opened up 

After the market correction of August and with political uncertainty receding somewhat after the summer, it seems like a window of opportunity has just opened up in the euro zone.  

In Italy, the new left-leaning and EU-friendly government has won a vote of confidence in the lower house of parliament. Prime Minister Giuseppe Conte, is on his second mandate and surviving the collapse of the 14-month alliance between the Five Star Movement (M5S) and the far-right Lega Norte. Today’s coalition unites the M5S and the centre-left Democratic Party (PD). Budget talks with Brussels should be smoother from now on. 

The European Central bank is also about to go through seamless changes with the nomination of Christine Lagarde at the start of November. Mario Draghi has recently announced a new package of various accommodative monetary policies and did not disappoint markets.  Fiscal stimuli will be key however as euro zone countries now have to take the lead from the central bank.  

The market correction during August and the budding bottoming out of leading indicators are encouraging us to go overweight while closely monitoring the market as well.  

The global slowdown continues but is now almost fully priced-in as expectations have been cut. 

Negative on Europe ex-EMU

Outside the EMU, the UK is still facing tougher challenges. There might be investment opportunities once the Brexit dust settles but for now, Prime Minister Boris Johnson has prorogued the UK Parliament for more than a month starting on the morning of Tuesday 10 September and until 14 October. A very controversial move on his part to limit the time spent debating the terms of a Brexit deal. 

If the UK reaches the October 31 deadline without having a withdrawal agreement in place, the legal default is that it will just leave the EU without a deal.

In the meantime, the political uncertainty is impacting domestic business activity and the currency, which is under pressure. 

We are therefore maintaining a cautious view on Europe ex-EMU, especially the UK.

Bonds and currencies

In terms of bonds and currencies, providing that the global economy avoids a recession, the macro-financial backdrop favours carry.  The highest carry can be found in emerging debt in hard currencies. 

We also remain invested in investment grade bonds. The global context, with an easing ECB, remains supportive, despite spreads tightening sharply since the beginning of the year. Carry to risk is attractive and the low yield environment supports credit. We favour EUR credit.

In the currency universe, we remain long yen and short USD, which should stop appreciating, and short GBP, in the light of political uncertainty and an economic slowdown. 

We are exposed to gold, as a hedge, based on the improving technical outlook and the upside potential in this asset class.