Our monthly view on asset allocation (May 2017)

The Great Recession of 2007-2008 and the ensuing debt crisis of 2011-2012 have pushed the euro area to Mordor and a "no future" economic land locked in a weak growth environment, plagued by high unemployment, mounting bad loans and lack of reforms. Dark clouds have been so persistent over the euro area that populism and political backlash raised to a point where the probability of disintegration has recently moved to a very likely event. It was especially frightening as this danger was coming from France, one of the founding members of the European project, which (re)conciliates both peripheral and core characteristics. In other words, the dark night was nigh despite Gandalf-Draghi doing whatever it took to avoid the worst.

Fortunately, like a good Hollywood movie, there has been a sudden and almost unbelievable turnaround which has brought a new wind of hope and freshness: according to the outcome of the first round of French presidential elections, the unknown Frodo-Macron is likely to be the next President. It’s like there was suddenly light at the end of the tunnel and with a clear and almost blue sky, investors are realizing that the economic outlook of the euro area isn’t as dark as previously perceived. Indeed, real GDP growth is currently running at around 2% –a level not seen since the short term recovery of 2010 – which is comparable, if not better, than the performance of the US market and is clearly higher than its potential – estimated around 1%. Moreover, there is a pent-up demand as unemployment rates should continue to fall from extremely high levels. The situation regarding bad loans should improve with a rising nominal growth tide, and a welcome dose of hope and reforms may jump start moribund investments by both domestic and foreigners companies.

In summary, the European recovery is quite new (and somewhat unexpected) compared to the eight consecutive years of expansion for the US economy. Trumpenomics and reflation hopes are already starting to fade away, while Macron may now be seen as the saviour who resuscitates the euro and the French’s splendour. As a result, we believe it’s now time to reload some risk in the portfolios and more specifically in European equities, which benefits from relatively interesting valuations and should thus attract significant foreign flows which had deserted markets in the last few years. Our duration stance has been downgraded slightly as there is now upward risk to German rates if investors start to price in a European tapering. We are still in a global scenario similar to Japan’s lost decades, at least as long as any meaningfully socio-economic-political reforms have been implemented. Europe is currently heading towards the top of the band’s range while US is probably already moving down. If we are right, US Treasuries are to be the "least worst" place to be in the govies space and the strong US dollar era is certainly behind us.

_Fabrizio Quirighetti

The current economic climate is almost as close to a ’goldilocks economy’ as it can get at a global level, with broad-based expansion, positive but low inflation and accommodative monetary policies across the board. This has allowed the Fed to engineer a “dovish hike” in March and the ECB to maintain its commitment to supportive policies while acknowledging improved economic conditions. If the main driver of this expansion – consumer spending fueled by rising employment – is set to remain in place in the coming months, factors suggest that parts of those dynamics may be on the verge of losing momentum. Confidence-based indicators are pulling back somewhat in the US after the impressive post-election surge, while actual activity data so far has failed to improve significantly. The impact of higher rates may already begin to dent credit growth and impact final demand. Inflation dynamics are reversing as oil-related base effects gradually fade away. As such, developed central banks find themselves in no rush to remove monetary policy accommodation, even if the trend continues to point toward gradual normalization. Overall, the outlook for the global economy appears, therefore, to be fundamentally positive, but not as positive to require a rapid monetary policy tightening.

Growth

The gap between “soft” and “hard” data has remained during the past month, as actual industrial production and consumption spending data have failed to improve significantly in developed economies. This fits into our expectations of limited upside potential for global GDP growth despite the bout of optimism witnessed at the beginning of the year. While downside risks have possibly diminished, global growth appears to remain stuck within its range of the past five years (3-3.5%).

Inflation

Inflation dynamics are already pulling back from their peak at the global level. The impact of base effects on oil prices and, for several EM economies, currency weakness is dissipating after having been the main driver of the 2016 acceleration in inflation. Underlying inflation and wage growth remain muted.

Monetary policy stance

The Fed and the ECB are walking a thin line of trying to withdraw accommodation without unsettling ongoing growth dynamics. The lack of underlying inflationary pressure pleads for cautiousness and gradualism. The UK may be one rare exception where the central bank must act more decisively if growth continues to defy gloomy predictions while inflation keeps rising. EM central banks are in an opposite dynamic of gradual relaxing of their policy but remain warry of inflationary pressures.

Developed economies

The US puzzle made of the large gap between “soft” and “hard” data is still there. Surveys of confidence and activity remain high even if they have pulled back a little in March, while actual industrial production, consumer spending and even job creations paint a subdued growth picture. While the former suggests 3% annualized GDP growth in Q1, the later point to below 1% growth. In any case, this environment and the lack of wage and underlying inflationary pressure mean that the Fed can hold a cautious stance for now, as nothing suggests it is behind the curve.

In Europe, all economic indicators still flash green and reflect broad-based ongoing expansion, above potential growth in most cases. However, underlying inflation remains subdued and even fell to a 2-year low in March, while headline inflation is already retreating as the impact of oil prices dissipate. Here too, the ECB has no need to rush into adjusting its monetary policy, especially if the final outcome of French and German elections remains uncertain.

In Japan, economic data continue to point to healthy growth while inflation hovers around zero. In such context, only a strong yen appreciation appears likely to eventually derail, the Bank of Japan has no reason – on top of having very limited means – to provide additional accommodation.

Emerging economies

Emerging economies continue to expand, supported by domestic demand. Higher energy prices also help oil-producing economies. On top of that, the pullback of the US dollar and the scaling down of US rate hike expectations reduce pressure on financing conditions. As such, most of the EM world is expanding and contributing to global growth with only a few exceptions, such as Brazil, still on a gradual path toward recovery. But some EMs are not out of the woods yet and face being dampened by domestic factors.

Growth stabilization in China fits into this positive global picture, helped by fiscal stimulus, fine-tuning on the credit distribution size and the easing of capital outflows and downward pressures on the currency. The Indian economy also exhibits an encouraging trend after the negative shock of the demonetization reform in late 2016.

_Adrien Pichoud

Risk and Duration

The result of the first round of the French election on the 23rd April was widely expected by market participants, with the upcoming second round having already reduced political tail risks in a meaningful way. The risk of a stand-off between Marine Le Pen and Jean-Luc Mélenchon in the second round has been eliminated, and opinion polls appear to be more accurate than what was the case with Brexit and the US elections which is encouraging. Macron leads the opinion polls for the second round by almost 30%, suggesting that the chances of a Le Pen victory are slim. Recognising risks in regards to the outcome of the French election means our stance on risk has been upgraded slightly to a mild preference. When it comes to duration, the stance has been revised to a mild disinclination. We continue to be concerned on bond valuations, which have become even more stretched in the run up to the French election, and with political risks having subsided, it is becoming less obvious that we will see a catalyst for a further compression in yields.

Equity Markets

Valuation wise developed market equities remain very dull. European equities score somewhat better on our metrics. This is not surprising given the almost persistent underperformance, relative to other developed markets – namely the US – over the last few years. Initially, the sovereign debt crisis held the European equity market back, it was then uncertainty about the economic recovery, and now more recently political risk. Given the fact that these risks are slowly disappearing, and investors are coming to terms with the more favourable economic backdrop in Europe, we have taken the decision to upgrade the European equity block, including Switzerland. Within Europe we believe that Italy and Spain look most attractive on a valuation basis. Spain has already been one of the best European equity markets year to date, leaving Italy as the market where there is clear upside potential. The Italian equity index is geared to financials and sentiment towards Italian banks still remains very negative. Moreover, even though the ECB’s narrative with regards to its outlook for monetary policy remains reasonably neutral, there is a case to be made that in the near future the ECB will have to rethink its stance and become more hawkish. This would benefit European financials in general and Italian banks in particular, given current valuations and sentiment towards the market segment. A more hawkish stance from the ECB will clearly boost the Euro, and might present somewhat of a headwind to more export driven northern European markets, as well large cap equities compared to small and mid cap equities.

Bond Markets

We remain concerned about bond valuations. Moreover, as political tail risks fade, it is difficult to see how yields can compress further from here. In relative terms Treasuries look somewhat more attractive than other high quality duration, such as JGB’s Gilts or Bunds, but then again this yield differential (at least from the perspective of a EUR investor) can only be locked in if one is willing to bear USD currency risk. The current 3-month for a Eurodollar hedge is 1.88% while the 10Y treasury yield is 2.31% therefore, after hedging the carry is 0.43% - barely 10bps more than the yield on bunds. While 10bps is quite a substantial difference when it comes to highest quality bonds, it is still difficult to treat such an investment as a yield investment. Duration wise, US Treasuries are, in our view, an undoubtedly better pick than other defensive bond markets. In the US, bond investors have already seen three interest rate hikes in the last 18 months and the potential for further hikes is well orchestrated. This is clearly not the case in Japan and Europe, opening the potential for further upward pressure on yields in these markets. Beyond the French election, one could argue that if Martin Schulz, the socialist candidate in the German federal election, was to become chancellor he could well join forces with Emmanuel Macron – if elected – and pursue an expansionary pro growth policy, financed by issuing Eurobonds. Talks about debt mutualisation would be clearly positive for equities, and peripheral government bonds, while opening the ceiling for bund yields to rise. It is true that such a scenario is mere speculation at this point nonetheless, the expensiveness of Bunds and JGB’s has triggered a downgrade to a strong dislike, while French government bonds have been upgraded to a dislike from a strong dislike.

Forex, Alternatives & Cash

Cash remains attractive, but less than before and it is becoming increasingly evident that the USD is finally losing steam. The JPY and EUR have been rather strong in recent months, and at least for the EUR we expect this to continue, supported by less political risk and increased inflationary pressures. Yet this appreciation is most likely to continue at a slow pace, with some degree of expectation management by the ECB.

_Hartwig Kos