Coffee Break 2/4/2019

LAST WEEK IN A NUTSHELL

  • The Fed shifted to a more dovish policy stance and vowed to be patient before moving its funds rate. This removes the risk of a monetary policy error in the next months and is supportive for risky assets if economic data stop deteriorating.
  • Westminster has asked for a new “Brexit” proposal and Theresa May has until February 13th to present a new draft agreement.
  • In a sign of good faith, China has agreed to increase imports of US products, including soybeans. With only a month to go before the truce ends, both sides cite progress but have stopped short of announcing a breakthrough.
  • The US job report was stronger than expected, particularly given the 35 days-long US government shutdown.

WHAT’S NEXT?

  • The start of the Year of the Pig is about to be celebrated in China during the entire week.
  • US President Trump will give a delayed State of the Union address before a divided Congress.
  • As for central banks, the Bank of England will meet, however no change in policy is expected.
  • The data calendar continues to be complicated by the impact of the US government shutdown as a large backlog of data releases have to be addressed.

INVESTMENT CONVICTIONS

  • Core scenario
    • In Emerging economies, activity has continued to soften. In Asia in particular, unintended inventories have piled up and this will continue to be a drag on industrial production.
    • In China, the downswing is not over: exports and industrial activity will stay weak for a while. But the measures taken by local authorities to support the economy should in the end allow the GDP growth to be on average around 6% in 2019. We note that the announced measures will imply more efforts in the future to put public debt on a sustainable path.
    • In the US, we expect growth to continue, albeit at a slower pace (2.4% on average in 2019 vs. 3% in 2018). Uncertainties related to trade are lingering but US president Trump is already hinting at an upcoming “deal”. Meanwhile, the Fed will stay “patient” to ensure a soft landing.
    • In Europe, the economic cycle is less dynamic (on average over 2019, GDP growth is expected to be at 1.4%). Policy risks persist. “Brexit” uncertainty in particular will not fade quickly. Given the current high level of inventories, this will have a negative impact on UK activity in the coming quarters. In the euro area, some temporary factors have depressed activity since last summer but lower oil prices and looser fiscal policies should however help the region steer clear from a recession.
  • Market views
    • Recently, markets priced in many risks, ranging from geopolitical uncertainties to central banks appearing out of synch. Valuations have come down sharply in 2018. Most of the de-rating is likely behind us as central banks have shifted towards a dovish stance.
    • We have kept our moderately constructive view on equities as we expect the global expansion to continue, albeit at a slower pace. We expect low to mid-level single digit profit growth.
    • We acknowledge that inflationary pressures will remain subdued as the price of oil has declined. An overall short duration remains warranted as the risk/reward remains unfavourable for most parts of the fixed income market.
  • Risks
    • Geopolitical uncertainties: They could tip the scales from an expected soft landing towards a hard landing.
    • Emerging markets slowdown: Emerging markets are among the most vulnerable regions when global growth slows down. Any fiscal or monetary measures taken to mitigate the impact of the trade war will help in the short term and weigh in the longer term.
    • EU political risks: Political pitfalls could fuel euro scepticism further as opinions diverge on a growing number of issues, i.e. “Brexit”, Italian public finances and social unrest in France and with EU Parliament elections across Europe this May. For now, the trade war initiated by the US has only impacted the euro zone indirectly.
    • Domestic US politics: A divided Congress, the forthcoming budget-related deadlines and dimming global growth prospects will weigh on US exports.

 

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

We have further increased our exposure to Emerging markets equities. Listening to the Federal Reserve, we gained more confidence in our central scenario and we expect a moderate equity market rise for 2019. We are comfortable with our current convictions on US and Emerging markets equities. We reduced somewhat our exposure to both Europe ex-EMU equities and Japanese equities. In the bond part, we keep a short duration and diversify out of low-yielding government bonds. Our fixed income preference goes to Emerging markets and High Yield.

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We have increased our overweight EM equities
    • We are overweight US equities. The latest communication from the US Fed is clearly supportive for the domestic economy. It removes the risk of monetary error in the next months. It could weigh on the USD. Rates increase should remain contained.
    • We have a small overweight euro zone equities. Slow growth and political uncertainties have increasingly been weighing on the stock market. Conversely, any conflict resolution is a potential trigger for a strong rebound.
    • We are 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 have little conviction on Japanese equities and have decreased somewhat our exposure. The cyclical economic momentum is becoming less favourable.
    • We are overweight emerging markets equities. A more dovish Fed is coming to the rescue and we believe in the growth of Emerging markets and while they have been badly hit by the trade war, a compromise between the US and China is on the horizon.
  • We are underweight bonds and keep a short duration
    • We expect rates and bond yields to rise gradually after the strong decline in recent weeks. The recent oil price decline may slow down the expected rise in inflation.
    • A slower but still expanding European economy could lead EMU yields higher over the medium term. There is an unfavourable risk/reward on core and peripheral European bonds. The ECB appears accommodative, but has ended its QE in December.
    • We see tactical opportunities in corporate bonds overall, in particular on US High yield.
    • Emerging market 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.