Coffee Break 1/7/2019

LAST WEEK IN A NUTSHELL

  • Markets started the new year with renewed appetite for risk as Fed comments and monetary policy easing in China had a stronger impact than the latest ISM manufacturing survey in the US which dropped sharply.
  • The trade war is felt by US companies too, as Apple had to cut its earnings expectations due to the economic slowdown in China.
  • Investors are pricing a more significant economic slowdown, as witnessed by the US Treasuries rally. Fed rate hike expectations have turned into a 30% chance of a rate cut this year.
  • From a political point of view, the House Democrats passed a spending package aiming at reopening the federal government through September. Chances are nevertheless high that either the Senate Republicans or the President will reject the proposal.

WHAT’S NEXT?

  • A US delegation will visit Beijing next week for trade talks, a first since the 90-day truce agreed last month.
  • US Trade Representative Robert Lighthizer is due to meet EU Trade Commissioner Cecilia Malmstrom in Washington to discuss bilateral trade liberalisation. They will also both meet with Japan's Trade and Industry Minister Hiroshige Seko on the subject of trade practices by China.
  • The minutes of the last FOMC will be released on Thursday. They will be more important than usual as they will give more insight on the likely debates that took place between members concerning growth worries going into 2019.
  • In the US, the December CPI will be released on Friday. The impact of the oil price decline on inflation data might give some new insight for the data-dependent Fed.

INVESTMENT CONVICTIONS

  • Core scenario
    • In the US, we expect growth to slow down to 2.6% in 2019 due to fading fiscal stimulus, trade policy uncertainties and tightening financial conditions.
    • 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 further easing in the face of a slowdown. China Premier Li urged the country’s three largest commercial banks last week to increase financing for small and privately-owned business. Li also said the government would increase economic support with additional tax and fee cuts and cuts to banks’ required reserve ratios.
    • The decline in the price of oil should pause the gradual rise in inflation in the US and in the euro zone.
  • Market views
    • US economy remains decent, and does not reveal any strong economic imbalances. The Fed is however appearing less hawkish and more data dependent.
    • Above-potential growth, on-going buybacks and no valuation excess vs. bonds should push 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: The US and China bought three months of time to resolve the structural issues. In the meantime, higher tariffs and protectionism are slowing down global economies, deteriorate international relations and ultimately corporate margins.
    • 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 finances, social unrest in France and 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. Our fixed income preference goes to Emerging markets.

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We have kept our equity exposure overweight and still have a constructive medium-term view. 
    • We are overweight US equities. Economic momentum stays decent although the fiscal stimulus boost is fading. We expect slower, but positive, earnings growth in 2019. Fed hiking is a headwind but the slowdown underway could moderate the Fed’s hawkishness as it is “data dependent”. 
    • We remain overweight euro zone equities. Slow growth and political uncertainties are increasingly weighing on the stock market. Conversely, 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 cyclical economic momentum is becoming less favourable. 
    • 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
    • We expect rates and bond yields to rise gradually after the strong fall in recent weeks. In addition to rising producer prices, rising wages 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. We remain underweight Italian bonds. The ECB remains accommodative, but has ended its QE in December.
    • We have a cautious 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.