Coffee Break 1/28/2019

LAST WEEK IN A NUTSHELL

  • Business and political leaders met in Davos, Switzerland to discuss the slowing global economy and climate change while PM May and Presidents Macron and Trump focused each on their homework.
  • In the Eurozone, trade tensions, consumer uncertainty, and political woes have translated into faltering economic growth as seen with the latest flash PMI and IFO readings.
  • The ECB noted that risks to the outlook have moved to the downside during its first post-QE press conference but left its policy stance unchanged, as expected.

WHAT’S NEXT?

  • Market participants expect no change in the Fed’s funds rate, but have high expectations from the press conference where chair Powell should outline its 2019 path and provide some clues over the future state of the balance sheet.
  • On Tuesday, Westminster will vote on the possible next steps regarding the “Brexit” negotiations. The GBP continues its rally, weighing on the domestic stock market.
  • The Chinese Vice Premier will be in Washington to discuss trade relations.
  • As the US government shutdown continues, Q4 GDP data will probably not be published but the US job report should show continued strength in the labour market.

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 business activity has been rather resilient and consumption is supported by a tight labour market. The Fed will stay pragmatic (“data dependent”) to ensure a soft landing. We expect two hikes in 2019.
    • 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
    • The world economy is slowing, but still growing. The various political risks are a headwind.
    • Expectations of slower earnings growth in 2019 are now widespread.
    • Valuations have come down sharply in 2018. Most of the de-rating is likely behind us.
    • If political risk recedes, there is a strong potential for a re-rating.
  • Risks
    • Trade war: Higher tariffs and protectionism are slowing down global economies, deteriorate international relations and ultimately corporate margins. China and the US have agreed on a short-term truce in this trade war. As the US wants to stay ahead of the game, especially in the Tech sector, the trade war is unlikely to evaporate quickly.
    • 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 weigh on their budget.
    • 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 impacted the euro zone indirectly.
    • Domestic US politics: A divided Congress, not to mention the current government shutdown, the forthcoming budget-related deadlines and dimming global growth prospects will weigh on US exports while the Fed normalisation is already affecting residential investments.

 

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

We are moderately overweight equities, as we expect in today’s environment and for 2019, an equity market rise. Our strongest convictions are reflected in our overweight US equities and underweight European ex-EMU equities. For Eurozone and Emerging markets equities we are looking to further increase our positions. We remain neutral Japanese equities where we see no catalyst. In the bond part, we keep a short duration. Our fixed income preference goes to Emerging markets and we recently added some US High Yield exposure.

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We have kept our equity exposure slightly overweight and still have a constructive medium-term view. 
    • We are overweight US equities. Economic momentum is fading but remains positive. We expect slower, but rising, earnings growth in 2019. The current slowdown is likely to moderate the Fed’s hawkishness as it is “data dependent”.
    • We have a small overweight euro zone equities and are looking to increase it. 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 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 and the developed markets’ slowing growth. 
  • 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. In addition to rising producer prices, rising wages and trade tariffs could push inflation higher.
    • A slower but still expanding European economy could 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.
    • The interest-rate differential between the US and Europe will remain high but should gradually reduce, on the long part of the curve, to begin with.
    • We have a cautious medium term view on corporate bonds overall but we see tactical opportunities in this asset class, in particular on US High yield.
    • 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.