Coffee Break 5/27/2019

LAST WEEK IN A NUTSHELL

  • Trade optimism faded, with the best near-term outcome being no additional tariff increases.
  • May flash PMIs in the US and the euro zone undershoot expectations, a sign that trade dispute erodes business confidence. As a result, US and German 10Y bond yield shivered and slid to 2.30% and -0.12% respectively.
  • In the UK, Theresa May announced that she would step down as Tory party leader and PM on June 7th. By doing so, she fired the starting gun on the leadership race to replace her.
  • The last FOMC’s minutes showed the absence of a strong case to amend interest rates either way. 
  • Belgian citizens went to the polls for the regional and federal elections on Sunday. Results showed huge gains for the far-right in Flanders and for the Greens in Brussels and Wallonia.

 

WHAT’S NEXT?

  • Trade will likely continue to dictate the tone of the markets with President Trump travelling to meet Japanese PM Abe and EU trade ministers gathering to discuss the threat of auto tariffs.
  • Populist and national forces are on the rise in an increasingly fragmented European Parliament (EP) but will not be able to move the EU in a different direction.
  • EU leaders will meet to start discussing the nomination of candidates for EU top jobs that will become vacant later this year, including the next Commission, EU Council, EP and ECB Presidents.
  • In China, official PMIs will be the important indicator to gauge the impact of the trade escalation.
  • In the US, the second estimate for Q1 GDP growth rate will be published.

INVESTMENT CONVICTIONS

  • Core scenario
    • We have a moderately constructive long-term view but are aware of political pitfalls, in particular the re-ignited trade conflict which may last longer than initially thought.
    • The political risk premium has increased again but the global economy is growing and seems to have hit its trough last winter.
    • We take some comfort from central banks which have become more dovish, leading to a sharp fall in bond yields.
    • In Emerging economies, the measures taken by Chinese authorities to support the economy will slowly show their impact. In parallel, the trade war just resumed as China will raise tariffs on $60bn in US goods early June.
    • In the euro zone, the economic cycle remains less dynamic: on average over 2019, GDP growth is expected to be at 1.3%.
  • Market views
    • Equity fund flows remain negative in recent weeks: investors are staying cautious in the light of recent trade tensions.
    • The corporate sector remains a large buying source via buybacks.
    • European and Japanese equity valuations are below their historical average, whereas US and Emerging markets are back to long-term averages.
    • Stabilising or improving macro data would likely lift global bond yields whereas chilling business activity and the escalating trade conflict will jeopardize confidence in the recovery.
  • Risks
    • The US – China trade conflict is at the top of the list. It could further weigh on output growth and trigger further spikes in volatility. We expect this to be a lasting issue, beyond trade.
    • Geopolitical issues (e.g. Iran) are still part of unresolved current affairs. Their outcome could still tip the scales from an expected soft landing towards a hard landing.
    • Political uncertainty in Europe (European institutions, “Brexit”, limited margin of manoeuvre).

 

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

While we stay overall neutral equities, our regional tactical tilts have shifted in the light of the evolving trade conflict. We have become overweight US equities and neutral Emerging markets equities. We decided to protect our overweight euro zone via options. We stay neutral Japanese equities and we stay underweight Europe ex-EMU. 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 have just become overweight US equities. We have a Trump put in addition to a Fed put, which makes the region a safer choice.
    • We have become neutral Emerging markets equities. The US Fed’s pause is a tailwind for the region but the trade war is a major hurdle. We still have a growth expectation above 6% for China this year.
    • We decided to protect our overweight euro zone via options. We expect a rise in the equity market but are aware of the restraining factors such as the vulnerability of global trade. The labour market and domestic demand remain decent. Most foreign investors have left the region, leading to a consensus underweight in spite of cheap valuation.
    • 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 stay neutral Japanese equities. Absence of conviction, as there is no catalyst. The region could catch up if the news flow around international relations improves and global growth renews with more traction.
  • We are underweight bonds and keep a short duration
    • We expect rates and bond yields, especially German 10Y yields, to rise gradually from depressed levels.
    • 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 is accommodative and will add a new TLTRO.
    • Emerging market debt has an attractive carry and the dovish stance of the US Fed represents a tailwind. Trade uncertainty and idiosyncratic risks in Turkey and Argentina are headwinds.
    • We diversify out of low-yielding government bonds, and our preference goes to US High yield, as a dovish Fed, low inflation and receding recession fears point towards the carry trade.