Coffee Break 3/25/2019

LAST WEEK IN A NUTSHELL

  • The US Treasury 3M-10Y yield curve inverted for the first time since 2007 as the Federal Reserve was the dove-iest surprise of all central banks, revealing a 50bp decline in the expected median rate path (dots) and an end to quantitative tightening as soon as September.
  • Among other central bank meetings, Brazil put the cursor on dovish tilt with a rate cut later this year and Norway hiked by 25bp, noting a “greater than 50% probability that there would be another rate hike in June”.
  • The flash PMI for the month of March confirmed that the economic slowdown was underway. In Germany, the manufacturing slump is deepening as export orders declined to a level last seen in the midst of the euro zone crisis in August 2012.
  • The EU Council and the UK government have kept all options open by postponing the “Brexit” day by at least a fortnight.

WHAT’S NEXT?

  • China’s President Xi is visiting European countries and will meet Mr Macron, Mrs Merkel and Mr Juncker in Paris.
  • US-China trade talks continue, with US officials visiting China.
  • The German IFO survey will reveal if the run of six consecutive monthly declines in the reading continues.
  • If Westminster approves a “Brexit” deal this week, the UK would be given a technical extension to 22 May. If no “Brexit” deal is approved, the UK would only be given an extension to 12 April and be required to inform the EU-27 as to how it intends to proceed.

INVESTMENT CONVICTIONS

  • Core scenario
    • We have an unchanged, moderately constructive long term view, but acknowledge the sharp market rally since the start of the year, which took place in a slowing growth environment.
    • The political risk premium has decreased and central banks have become more dovish since.
    • Macro data is weakening and should reach a trough in H1 2019 but economic surprises are still negative. We are waiting for an actual improvement of hard data or a more tangible, positive outcome on the trade war front.
    • In Emerging economies, activity continues to soften and 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.
    • In the US, we expect growth to be at a slower pace than in 2018. The Fed will stay “patient” to ensure a soft landing.
    • In Europe, the economic cycle remains less dynamic and continues to disappoint (on average over 2019, GDP growth is expected to be at 1.2%). Looser fiscal policies should help the region steer clear from a recession.
  • Market views
    • Equity fund flows have been negative in recent weeks despite positive performance of markets.
    • The Corporate sector itself remains a large buying source via buybacks, but the “black-out“ period ahead of the Q1 earnings reporting is starting at the end of this month.
    • Equity valuation is now at “fair” levels and spread compression also reveal that risk/reward has become less attractive than at the start of the year.
    • European and Japanese equity valuations are below their historical average, whereas US and Emerging markets are back to long-term averages.
    • A downshift after the recent advance and / or better macro data would present an opportunity to put money back to work and increase the risk budget again.
  • Risks
    • Geopolitical uncertainties have not been resolved yet and could still tip the scales from an expected soft landing towards a hard landing.
    • International trade relations remain a source of uncertainty and could further weigh on output growth.
    • Persisting slowdown in Europe and Emerging markets in spite of easing measures.

 

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

We are neutral equities. We took some profits as our overweight stance in previous months enabled us to benefit from the recent market recovery. From a regional perspective, all regions have been neutralised, with the nuance of a preference for EMU equities over Europe ex-EMU due to the unresolved “Brexit” issues. 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 neutral equities
    • We are neutral US equities. We expect slower, but positive, earnings growth in 2019. Equity valuations have recovered as stock prices rose and earnings expectations were cut. A divided Congress and forthcoming budget deadlines represent a risk.
    • We are overweight euro zone equities. Macroeconomic figures are weakening but domestic demand remains solid, as shown by the Services PMI. Most foreign investors have capitulated and valuations remain cheap despite the 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. Absence of conviction, as there is no catalyst.
    • We are neutral Emerging markets equities. The Fed pause is a tailwind for the region but Chinese growth is the key driver: monetary support and fiscal easing should ensure a growth target above 6%. Trade conflict is not resolved, even though the risk of new tariff hikes has decreased.
  • 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.
    • 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 will add a new TLTRO.
    • Emerging market debt has an attractive carry butgrowth fears due to trade war rhetoric represent potential key risks.
    • We diversify out of low-yielding government bonds, and our preference goes to US High yield.