24 JAN

2017

Asset Allocation , Topics

Global growth is expanding in a synchronised way

Executive Summary

  • Global growth is expanding in a more synchronised way. Activity indicators are accelerating, with the exception of the UK.
  • Central bank stimulus is still significant, except in the US. The Fed’s balance sheet is stable and the central bank forecasts three interest rate hikes this year.
  • We are maintaining our cautious positioning in UK equities and a short position on the GBP against EUR, as we believe the negative Brexit impact is not yet fully reflected in the exchange rate after the rise in the British pound at the end of last year.
  • We remain overweight equities via US, Eurozone and Japan.
  • We are maintaining our neutral position on emerging markets: despite attractive valuations, upside is limited due to USD strength and higher-trending interest rates and potential protectionist measures.

CROSS-ASSET STRATEGY

Global growth is expanding in a synchronised way

United States: accelerating activity

Economic activity indicators are showing signs of acceleration, with an upward revision in GDP growth to 3.5% in Q3. The US continues to approach full employment and wages continue to rise. Following its December 14th meeting, the Fed has increased its rates by 25bps and surprised markets by becoming more hawkish with three interest rate hikes forecast this year. However, given the recent tightening in financial conditions, the central bank is likely to wait for more clarity on Donald Trump’s economic policies before raising rates. We still expect stronger growth based on Donald Trump’s fiscal stimulus programme, but recognise that a great deal of uncertainty surrounds this scenario. As a result, we have maintained our GDP forecasts in the United States at 2.3% in 2017 and 3.3% in 2018.

Euro zone: resilient to persistent political uncertainty

Recent surveys point to some acceleration in activity, with improving economic sentiment and stronger PMI indices. Meanwhile, consumption should remain firm, supported by an improving labour market. Furthermore, the recent depreciation of the euro is favourable to exports and overall GDP growth, while pushing inflation somewhat higher. Despite the retreating economic policy uncertainty in December, political risk remains high with elections scheduled in the Netherlands, France and Germany, and the expected start of the Brexit negotiations. However, liquidity remains ample thanks to significant central bank stimulus.

In this context, we have maintained our GDP forecast in the euro area at close to 1.5% in 2017 and 2018.

Central banks are decoupling

The expected monetary policy gap between the US and the rest of the world is likely to increase in the coming months. The Federal Reserve tightening cycle is ongoing, while monetary policies in Japan, the Eurozone and the UK remain highly accommodative.

  • The Fed increased its rates by 25bps in December and forecast three interest rate hikes this year.
  • The Bank of England remains supportive.
  • The Bank of Japan is innovating with yield-curve targeting through unlimited bond buying.
  • The ECB will extend its asset purchase programme beyond March 2017 for nine months through end of December 2017. However, the asset purchases will be reduced from €80 billion to €60 billion per month starting from April.

Italy, a medium-term risk for the Euro area

Although political uncertainty has eased somewhat recently in the Euro zone, Italy remains weighed down by weak economic recovery, slow reform implementation and bank recapitalisations.

  • The job market situation is still challenging and the strong job creation over the last two years, mainly due to temporary fiscal advantages, should slow down.
  • The rise in inflation supported by a rebound in energy prices, should weigh on purchasing power.
  • Productivity gains have been worryingly weak compared to other euro countries.
  • Since the crisis, the public debt-to-GDP ratio has increased by 30 points with a non-financial sector debt-to-GDP ratio rising rapidly, while growth has stalled. Unless Italy improves either its structural balance or its potential growth rate, public debt will remain on a unsustainable trajectory.
  • The Italian banking sector is now weighed down by heavy non-performing loans: the ECB estimated the capital shortfall of Monte dei Paschi, the country’s third biggest lender, at 8.8 billion euros.

In this context, we expect modest GDP growth of 1.2% in 2017 and 1.0% in 2018 for Italy.

Cross-asset: overweight in equities

The global context remains supportive for equities. Improving economic momentum and a decline in European policy uncertainty justify decent equity market performances. The BofA Merril Lynch Fund Manager survey shows that positions in equities have risen to a 12-month high.

In terms of asset allocation, risk appears to have switched from equities to bonds, as the prospect of a US recession in 2017 has sharply diminished. Furthermore, equities have an attractive relative valuation compared to credit, and their expected return should be boosted by the end of the earnings recession in the US. However, we remain cautious due to the uncertain political environment, and have therefore adopted an overweight stance in equities.

REGIONAL EQUITY STRATEGY

Constructive on US and Japanese equities

  • We are positive on US equities. We expect stronger growth and a rise in corporate earnings in the prospect of post-election reflationary policies and consolidating oil prices. Also, the US tends to outperform in periods of market uncertainty. However, the unpredictability of the new US president could lead to upside or downside risks.
  • We remain positive on Japan. The country benefits from improving activity indicators, a supportive domestic policy mix, relatively attractive valuations and a weaker yen. The correlation between Nikkei and Yen remains very high as currency depreciation is synonymous with upward earnings revisions.

Sligthly overweight on euro zone equities and negative on the UK

We still believe in the possible re-rating of euro zone equities driven by their attractive valuation, an increase in corporate profits and positive investor sentiment as political uncertainty is receding.

  • Political uncertainty: a retreat towards the median EU uncertainty level since 2011 would help further euro zone outperformance.
  • Economic momentum: although starting to look toppish, economic surprises have further improved.
  • Earnings growth: earnings revisions are improving and we revised EPS growth to around +7% (+1% revision).

However, uncertainty could resurface when Brexit negotiations start and the road ahead is paved with many political risks. This justifies our slight overweight on euro zone equities, while remaining negative on UK equities:

  • The UK government acknowledged the strongly negative impact of Brexit on revenues. Furthermore, a deterioration in domestic UK macro indicators should hit the FTSE250 which has significant domestic exposure. In particular, we avoid domestically-oriented small and mid-caps.
  • Relative valuation is rather expensive, as earnings have dropped over recent years.

Relative to the US, the Euro equity performance has recouped some ground.

Neutral on Emerging markets

Despite the fact that emerging markets are still attractive, they are our lowest conviction. Economic momentum is improving, earnings are expected to grow and valuations are appealing, but possible protectionist measures coming from the newly-elected US administration may impact the region’s relative performance. In addition, USD strength and the increase in US rates represent a drawback.

Meanwhile, India remains our preferred emerging market thanks to:

  • Improving fundamentals with 7.4% GDP growth expected in 2017 and receding inflation.
  • An improving current account which makes India less vulnerable to external influences, a major theme since Donald Trump’s election and possible protectionist measures.
  • Supportive domestic reform agenda in the long run, despite being currently penalised by bank note issues.

FIXED INCOME STRATEGY

Broad diversification out of low-yielding bond segments

  • Following Donald Trump’s election, we have maintained our strong conviction on a longer-term rise in US bond yields. Although, we had tactically taken some profit on our underweight in duration, we increased it again by the end of the month. We continue to favour a short on US Treasuries.
  • We are maintaining our slight overweight on high yield. The significant tightening among spreads has reduced the potential, but the carry remains attractive.
  • We have a slight overweight in emerging debt, both in local and in hard currency. Emerging debt spreads have reached our target, but are still attractive compared to US Treasuries. Nevertheless, we remain cautious, as a stronger USD and higher US yields imply downward pressure on currencies.
  • We remain positive on inflation-linked bonds:
    • We expect an increase in observed inflation and outlook, due to a sustained rise as a result of the US fiscal easing, rising wages and receding Chinese deflationary pressures.
    • Oil-price base effects represent the main inflation increase driver for Q1 2017.
    • US headline CPI to come in above 2% in December for the first time since mid-2014 and should peak at levels close to 3% during Q1 2017.

COMMODITIES STRATEGY

Commodities continued to perform well in December, boosted by an impressive year-end rally in the oil price. Brent crude jumped to above 55 USD/barrel as the markets await evidence of OPEC supply reductions in 2017. However, US oil production is likely to rise if the Trump administration acts in favour of drilling and possible deregulation, as could be expected. Moreover, industrial metals should benefit from expected US infrastructure spending.

Separately, gold dropped strongly to 1,200 USD/oz, driven lower by rising US yields and the decline in ETF holdings of gold.