Coffee Break 11/12/2018

LAST WEEK IN A NUTSHELL

  • Global services and composite PMIs confirm expansion but at a slower pace with figures above 50 but on a decreasing trend from the previous high levels. Italy has fallen below the expansion/contraction threshold of 50pts.
  • Yesterday marked the 100th anniversary since the end of WWI. Several leaders met in France, including Presidents Trump, Macron and Putin.
  • OPEC producers met in Abu Dhabi to discuss the state of the oil market as the US produce more than they used to and are at odds with some of the OPEC countries and as US sanctions on dealing with Iran have become applicable.
  • Midterm elections have resulted in a split Congress, as expected. Policy gridlock – or intense deal making - are in sight in Washington.

WHAT’S NEXT?

  • Italy’s government is due to present a revised 2019 budget to the EU by Tuesday. This tug of war is contributing to the higher risk premium of European equities.
  • The “Brexit” withdrawal deal is said to be about 95% complete. The final resolution has to be approved by Parliament before visibility is restored.
  • On the data front, inflation and Q3 GDP growth figures will be published in key countries, including Europe, the US, Japan and China. 

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 and higher tightening financial conditions. The Fed maintains its tightening path.
    • Outside the US, the economic cycle is less dynamic. European momentum is disappointing and policy risks remain.
    • Although the US-China relationship appeared fractured not too long ago, recent talks have given hope to believe that a breakthrough was in the making. It is worth remembering that China would also have to agree, 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 economic momentum remains strong, but 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: the evolution of the USD liquidity is key for emerging countries due to outstanding debt in this currency.
    • EU political risks: political pitfalls could fuel euro scepticism 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 have tactically increased our equity exposure to overweight via the euro zone, as equity markets reached an attractive technical level. From a regional perspective, we are overweight euro zone and US equities, while being neutral emerging markets and Japan. We continue to hold a negative view on the UK, as “Brexit” issues are not resolved. In the bond part, we keep a short duration and a cautious view on Italy.

 

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We have tactically increased our equity exposure to overweight and still have a constructive mid-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 have tactically increased our overweight on euro zone equities. We have witnessed a disappointing slowdown in the expansion as momentum has vanished. Political uncertainties are accumulating, but are already priced in. Any relief would trigger 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. 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 neutral emerging markets equities. We are looking for lower technical levels to step in again. Global growth remains decent for the foreseeable future and emerging markets assets as a whole have already incorporated a risk premium for a tightening Fed, a strong USD and trade war risks.
  • 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.