Coffee Break 2/25/2019

LAST WEEK IN A NUTSHELL

  • The FOMC minutes from the January meeting confirmed that the tightening pause is for real and an end to the balance sheet reduction for the end of the year.
  • The latest minutes showed that the ECB is no longer in denial of the current slowdown. It has started to address the pain as it prepares some policy options for future liquidity operations.
  • US and China negotiations have progressed enough for global risky assets to end the week on a rising note.
  • US, euro zone and Japan flash PMI showed a slowdown in manufacturing activities but services managed to stay afloat, supported by solid domestic demand in the respective areas.
  • The UK equity market also caught a break ahead of next week’s Westminster vote on “Brexit”.

WHAT’S NEXT?

  • And the winner is... the delay in the tariffs increase, so far scheduled for 1 March, as the US has made substantial progress in trade talks with China, implying that tariffs on China’s goods have likely peaked.
  • Overbought and under owned: 91% of S&P constituents are trading above their 50-day moving averages, but investor positioning remains light as there is a perception of a disconnection between macroeconomics and equity volatility.
  • The Fed’s Chairman is due to deliver a statement on the monetary policy report in front of Congress. The upcoming end of the balance sheet reduction should be the main focus.
  • Donald Trump and its North Korean counterpart, Kim Jong Un, will meet for the 2nd time.
  • On the data front, consumer confidence readings in Germany and France and the US Q4 GDP growth rate are due.

INVESTMENT CONVICTIONS

  • Core scenario
    • In Emerging economies, activity continues to soften. Major central banks, including the Fed, the Bank of England and the European Central Bank, list international trade relations as a source of uncertainty. The measures taken by Chinese authorities to support the economy should result in a GDP growth of around 6% in 2019. Such measures will benefit the broader region. 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 a sustained growth, albeit at a slower pace (2.4% on average in 2019 vs. 3% in 2018). Meanwhile, the Fed will stay “patient” to ensure a soft landing.
    • In Europe, the economic cycle remains less dynamic (on average over 2019, GDP growth is expected to be at 1.4%). The current economic situation continue to disappoint but expectations for a turnaround are improving. Policy risks are manifold. But lower oil prices and looser fiscal policies should help the region steer clear from a recession.
  • Market views
    • Investor risk appetite remain extremely low and has not yet recovered since the start of the year. As a result, investor positioning is light and allocation to cash has risen further. If consensus realises that the world economy is in a slowing, but growing economic environment, risk taking could increase throughout the year.
    • Participating in the rally at the start of the year was key. We are slightly overweight equity for the entire year and recognise that markets would need good news beyond central bank dovishness (trade, political risks, growth stabilisation) to rise further. We would tactically wait for some retracement before further increasing our equity exposure. As investor positioning is light, it would however need unexpected bad news to trigger a sharp fall.
    • Opportunities lie in more central bank liquidity and dovishness, widespread pessimism and low positioning, stronger rebound of economic growth or political risks relief.
  • Risks
    • Geopolitical uncertainties: They could tip the scales from an expected soft landing towards a hard landing.
    • Emerging markets slowdown: Any fiscal or monetary measures taken to mitigate the impact of the trade war helps in the short term and weighs 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 this May. For now, the trade war initiated by the US has only impacted the euro zone indirectly but the US DoC reports on the EU car industry's security threats are due.
    • Domestic US politics: A divided Congress, the forthcoming budget-related deadlines and slow global growth will weigh on US exports.

 

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

We are overweight equities via the US and Emerging markets. We remain tactically neutral euro zone equities. We are strategically underweight Europe ex-EMU and neutral Japan. In the bond part, we keep a short duration and diversify out of low-yielding government bonds.

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We are overweight equities
    • We are overweight US equities. The US Fed is clearly supportive for the domestic economy. It removes the risk of monetary error in the next months and rates increase should remain contained.
    • We are tactically neutral euro zone equities. Macroeconomic figures are weakening but the labour market stays strong and that will help support consumption. Political uncertainties are a drag. Conversely, any conflict resolution will appease markets.
    • 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 neutral Japanese equities. Absence of conviction, as there is no catalyst.
    • We are overweight emerging markets equities. A more dovish Fed is good news for the region. We believe in its economic growth potential and while they have been badly hit in 2018 by US trade negotiations, they have been resilient.
  • 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 currently low oil price slows 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 carry on core and peripheral European bonds. The ECB appears accommodative and could add a new TLTRO, but has just ended its QE.
    • Emerging market spreads have tightened in the current, more optimistic, context. However, we would need new performance triggers for another spread tightening. Hence, we have decreased our exposure and took partial profit.