Asset allocation flash – 25 June 2018
SUMMARY: Despite trade tensions, concerns about global growth and more volatile markets than in 2017, our base case scenario remains one of robust global growth and contained inflation. This underpins our bullish view on equities, with a preference for eurozone equities where we see positive earnings growth prospects and room for margin expansion
- We foresee calmer markets over the next few months and have identified several reversal themes: (i) The crude oil market has likely seen a top already as it priced in plenty of good news on demand, supply and geopolitics. (ii) Relative monetary policy divergence between the US Federal Reserve and the ECB is also largely priced in. We therefore expect the USD to stabilise against the EUR and the spread between German and US Treasury (UST) bond yields to tighten after almost a year of widening. (iii) More stable US rates markets and a stable USD should support emerging market (EM) currencies and therefore EM local debt.
- In line with these views, we have recently taken a long position in US Treasuries versus German 5-year bonds and we will look for opportunities to add long EM FX exposure, for example by adding to our existing long EM local debt position.
- The main risks to our bullish base case scenario could stem from an inflation surprise or an escalation of trade tensions that could lead to a global economic slowdown.
- Our market dynamics analysis (technical dynamics analysis, financing conditions, market dynamics indicators, liquidity monitoring) had already flagged a change in the environment early in 2018, suggesting a more febrile market. In this context, we maintain our positive view on risky asset in the next few months, while we continue to monitor market movements closely.
Following a strong performance for risky assets in 2017, markets have experienced some challenging cross currents over the past few months. The market moves over the past three months are a good example of this new and more challenging environment (Figure 1).
Equity performance was mixed with positive returns in the eurozone, followed by the US, and EM equities trailing with negative returns.
Read our latest asset allocation flash update here
So far so good, but markets underestimate risks
SUMMARY: US equities continued to outperform other markets such as EMU and EM equities. This partly reflects the divergence between the US economy -which is supported by fiscal expansion and a patient Federal Reserve- and relatively weaker growth in the eurozone and EM. But there is more to this divergence than faster US economic growth. The US equity rally has been led by the IT sector. This has accounted for 20%-50% of US equity returns since 2016. The rally is now looking stretched on various metrics. The other salient development in August was renewed stress in emerging markets (EM). A combination of economic stress in Turkey, weaker growth in China, Sino-US trade tensions and a stronger US dollar hurt EM assets. We believe there is value in EM assets, but the obvious circuit-breakers are still absent: a weaker USD, aggressive China stimulus and fresh Sino-US trade talks. EM assets prospects have soured and protectionism and tighter liquidity continue to cloud their longer-term prospects.
Foreseeing calmer markets over the next few months, we have identified several reversal themes
Asset allocation – June 2018
Three stocks hit markets: (i) an escalation of political risk, (ii) weakening growth (notably in Europe); and (iii) a stronger USD, which led to stress in emerging markets In Italy, market worries about fiscal excesses and the prospect of a clash between the new government and European authorities escalated. As a result, ‘peripheral’ eurozone debt sold off. Italian markets are likely to remain volatile in coming months as investors digest further news on political developments and economic data There are signs of a growth slowdown, notably in the eurozone, according to recent data. However, we find it difficult to call a turn in the economic cycle yet. While the data have weakened, activity is still expanding both in the developed world and emerging markets Emerging market stress was largely a consequence of higher US yields and USD strength. In our view, local debt offers value and currently lower US yields are reassuring, but we need to see the USD and global risk sentiment stabilise for EM debt to rally materially
25 June 2018