Fed first rate hike remains a concern for investors

Cross asset strategy

Current rebounding economic data in the US support the case for a second phase of normalisation in the US financial environment in September, the month in which economists’ consensus expects a first rate hike. The Fed indicated at its last meeting that it would be cautious and continue to closely monitor communications. Until now it has been more dovish that expected.

The Fed can nevertheless afford at least a first hike in H2 without taking too much risk, given the global context of abundant liquidity. The ECB and the BoJ will continue to inject huge amounts of liquidity into financial markets (EUR 60bn/month and YEN 80trn/year respectively) for some time: in Europe, for instance, the duration of the programme is linked to an improvement in the inflation outlook and will last until September 2016 or “until a sustained adjustment in the path of inflation”, according to Mr Draghi.

We do not see a strong increase in yields either in the US or in the euro zone until year-end (our target is 2.7% for the 10Y US rates and around 1% for 10Y German rates). Now that yields are closer to fair value, the selling pressure should decrease, making volatility maybe easier to manage.

REGIONAL EQUITY STRATEGY

Euro zone equities should continue to outperform

Equities retained their attractive valuation compared to bonds, despite being less appealing in absolute terms.

After recording strong performances for several months now, equities are less attractive in terms of absolute valuation, as the current 16.6 level of the MSCI World PE ratio is above the 15.7 median level.

We favour euro zone over US equities

In anticipation of the stress linked to Greece being contained, our scenario in relation to euro zone equities remains intact:

We continue to play the cyclical upturn in the euro zone , with stronger earnings growth that will support equities. The single currency area and Japan are clearly expected to make the difference this year. Indeed, US and UK earnings growth is expected to be in deceleration or negative this year, mainly due to the impact of the energy sector.

• Euro zone equities have a more attractive valuation when compared to bonds than US equities.
• Euro zone equities are benefiting from improved momentum. Year-on-year earnings growth has been positive since the second half of 2014 and should continue to deliver in 2015, while US earnings are being penalised by a strong USD and the energy sector.
• The euro and oil price depreciation should continue to be favourable to euro zone equities.

Preference for Chinese equities within emerging markets

Emerging market equities seem to be quite cheap (PE at 11.79, slightly above the median) but, relative to their earnings growth, this inexpensiveness is less obvious. Furthermore, there is a lot of dispersion among the various emerging countries, sectors and individual stocks. Various macroeconomic forces are at play here, such as the commodity-price decline, the increase in the USD and economic policy divergences. We have a preference for Chinese equities. After the surge in mainland Chinese equity markets over the past 12 months, Hong Kong stocks, having reached their highest valuation discount since 2011, should continue to benefit from the improved conditions for using the cross-border link between the Shanghai and Hong Kong stock exchanges. We expect the valuation gap to continue to shrink.

Positive on Japan

We have maintained our positive stance on Japan. The arguments for this remain intact.

• Valuations are attractive and the BoJ’s additional measures should trigger a potential increase in earnings.
• Investors expect a substantial future increase in shareholder returns, helped by solid earnings growth and strong cash holdings.
• The change in the asset allocation of the GPIF, Japan’s leading pension fund, is indicative of the sustainable support for Japanese equities.

FIXED INCOME STRATEGY

We have a preference for diversification towards high-yield and emerging debt

We are still underweight in government bonds, as there is less of a cushion to absorb any increase in rates, especially in a context of the first interest rate hike in the United States during the second half of the year that will bring the zero-interest rate environment to an end. Therefore we continue to diversify our bond portfolio to riskier, higher-yielding bonds, which continue to be supported by the combined actions of the ECB and the BoJ (which are easing financial conditions) and by the more cautious approach that the Fed could adopt in its management of the interest rate increase.

Moreover, as high-yield and emerging debt still offer the best carry-to-risk ratio (risk-return measure: yield-to-maturity divided by 1-year volatility), we have kept our overweight position in these asset classes.

COMMODITIES STRATEGY

Still too early to be positive on commodities

Although probably a lot of the bad news on excess supply and lower global economic growth has already been discounted, it is still too early to turn positive.

Oil: the continuing slowdown of the fall in the US oil rig accounts for the evolution of the oil prices. Althogh the latter are bottoming out, the price recovery will be longer term. In fact, the oil price rebound does not reflect the situation of the physical market: US crude oil inventories are still at a high level, OPEC countries continue to produce massively (above the call on OPEC) and hopes of a deal between Iran and the six world powers (UN Security Council plus Germany) have increased fears that Tehran crude oil could exacerbate the current oversupply.

Base metals are being penalised by the disappointing activity in the US and Chinese manufacturing sectors of the first months of the year. Nonetheless, the oversupply problem is going to be resolved for some base metals such as copper, zinc and nickel, with supply shortages from 2016-2017. We consider it too early to invest in this asset class.

Finally, gold prices are negatively correlated with US real interest rates, which should finally start to increase in 2015.