When geopolitical issues get in the way of fundamentals

MAIN CONVICTIONS

• The business cycle, which keeps moving forward, has likely peaked, and increasing bond yields are already resulting in sectorial rotation.
• We’re staying constructive on equities, but with more moderation.
• We’re maintaining some cautiousness on credit and a negative tilt on bonds, with the exception of inflation-linked bonds and emerging market debt.
• The main risks to our moderate equity bullish base scenario include a sudden halt to the current expansion, an extreme tightening of the USD liquidity and spiralling geopolitical tensions. 

GLOBAL CROSS-ASSET STRATEGY

With the US mid-terms in sight, the trade war against China will persist, as it is one of Trump’s core missions. However, China has been resourceful up until now in mitigating the impact without going full-frontal against Trump. Meanwhile, the EU’s economy is still expanding, albeit at a slower pace, but the anti-European rhetoric is growing and not just in the south.

Fundamentals are key to market performance. In the US, they’re telling us that the expansion is accelerating. Hence the Fed will pursue its rate normalization. The labour market is tight. Unemployment hit a 48-year low at 3.7%, but statistics show that it is getting harder to find qualified staff. US earnings growth might have peaked but remains very well oriented. A persisting divergence in regional performance is putting the US ahead of the rest of the world, but the mid-term elections are fast approaching. If history is any guide, the Democrats have a reasonable probability of winning the House. If they do, this could call into question the current asset allocation: positioning is starting to be crowded on US equities, and US yields are rising.

In Europe, the economic cycle is less dynamic. However, 2% GDP growth is still expected. The biggest hurdle is the forceful return of political uncertainty. Besides Brexit and the rise of anti-Europe/anti-immigration rhetoric in Sweden and Germany, where economic policy uncertainty is on the rise ahead of the elections in Bavaria and Hessen, Italy’s new coalition presented a new government budget that took Italian spreads halfway to 2011 crisis levels, as it seems overly optimistic and on a collision course with EU fiscal rules, another reason for Italy to voice its disapproval of Brussels’ interference.

In Japan, the re-election of Shinzo Abe as Prime Minister for a 3rd and final mandate means another three years of Abenomics. In anticipation of next year’s consumption tax hike, fiscal policy is set to stay loose, thereby  supporting both growth and inflation. The monetary policy is also expected to remain accommodating for longer. The Bank of Japan will likely be last in starting a normalization process, keeping the Yen’s value low. The government has really put the emphasis on rewarding shareholders. The Japanese equity market has performed well, profit growth has increased and current investors are mostly domestic. With the economy doing well, it is just a question of time until foreign investors’ outflows return to pre-Q1 2017 levels.

In Emerging Markets, Emerging-specific country risks have increased: the currency crisis in Turkey, political unrest in Argentina (which is experiencing recession and where inflation is super-high), and China having to bear the brunt of Trump’s wrath so far in the on-going trade war. Risk premiums are now integrated in terms of currencies and equity markets. On the upside, China has been resourceful up until now in mitigating the impact, using an accommodative policy mix. Other countries have raised rates to offset the strengthening USD.

In this context, we are definitely staying constructive on equities, but with more moderation. The business cycle, which keeps moving forward, has likely peaked, and increasing bond yields are already resulting in sectorial rotation. Our 1-year expected returns are close to double-digit growth for equities. We believe that there is more potential in the euro zone and Emerging Markets as the risk premium is higher. In the meantime, we are maintaining some cautiousness on credit and a negative tilt on bonds, with the exception of inflation-linked bonds and emerging market debt. The main risks to our moderate equity bullish base scenario include  a sudden halt to the current expansion, an extreme tightening of the USD liquidity and spiralling geopolitical tensions.