Last week, investors’ attention shifted to the FOMC on Wednesday. As widely expected, the Fed funds rate was raised by 25bps to a range between 1%-1.25% amid a robust job market and a moderately rising economic activity. In the small business sector, hiring plans hit a new high for this economic cycle. The Fed expects inflation to remain somewhat below 2% in the near term but to stabilise around the 2% objective over the medium term. Besides the rate hike, the central bank announced it would start reducing its balance sheet this year providing “the economy evolves broadly as anticipated”. Also, the so-called “dot-plot” remained unchanged, indicating an additional hike before the end of the year and further three in 2018, which are currently not priced by the markets.
Further in the US, the credibility of the Trump presidency is questioned as the President has publicly acknowledged that he is under investigation. As a consequence, there is an execution risk (at least a delay into 2018) in the expected fiscal stimulus.
Following the surprise election outcome in the UK, the scenario of a softer “Brexit” has gained in probability although the path towards it should be bumpy. Paradoxically, the election outcome has also reinforced the case of the opposite scenario, namely a disorderly “Brexit”, but we think that all parties involved, in particular the EU, will try to avoid this. Our conviction is that the biggest part of GBP depreciation seems behind us and that UK stocks should not benefit from upcoming GBP moves and only suffer from weak fundamentals. Our overweight on euro zone equities and underweight on Europe ex-EMU equities remain intact.
This week, we will closely follow the effective start of the “Brexit” negotiations between the UK and the European Union.
Our current investment strategy on traditional funds:
grey : no change
blue : change
EQUITIES VERSUS BONDS
We are tactically neutral on equities and remain negative on bonds, maintaining a short duration:
- Global expansion dynamics are less uniform than at the turn of the year. The economic news flow is less supportive in the US and we lack a catalyst or a market setback for becoming more constructive. The European recovery is well on track and should lead to above-potential growth in 2017-18, leading us to raise profit expectations. We think that the euro zone and emerging economies are best placed to leverage on these dynamics.
- Central banks dovishness to recede very gradually:
- Mario Draghi’s ECB left its monetary policy unchanged, though stating that it “considers risks to the growth outlook as broadly balanced”. Even though Mario Draghi denied that there was any discussion regarding an eventual tapering, the ECB has taken its very first little step towards exiting its massive stimulus by omitting the lower interest rate levels in its forward guidance. Tapering should become a central theme after the summer.
- The Fed increased its funds rate for the fourth time in this cycle and gave more details on how it could start reducing its balance sheet “relatively soon”, although no specific date was provided.
- 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 and Europe.
- The main risks for equity markets remain political and have switched from Europe to the US:
- Italian elections are unlikely to be held in 2017.
- The UK elections outcome has led to more uncertainties on the tone of the “Brexit” negotiations.
- The geopolitical tensions in Syria, North Korea and potentially Iran may cause uncertainty.
- The slippage in the timing of the fiscal stimulus due to the lack of political success in Congress and the investigation targeting the President question the credibility of the Trump presidency.
REGIONAL EQUITY STRATEGY
- We remain positive on euro zone equities. The on-going, more robust and geographically broadening economic expansion, an accommodative central bank and a strong corporate earnings momentum underpin the attractiveness of the region’s risky assets. Furthermore, relative valuations are attractive and non-resident flows should continue to pick up.
- We maintain an underweight on Europe ex-EMU. The uncertainties surrounding the UK’s political situation, the “Brexit” negotiations and the impact on the economy leads us to avoid the region.
- We keep our neutral stance on US equities. The US cyclical recovery stalled in Q1 and activity data has yet to catch up with survey optimism. Donald Trump’s unpredictability adds to the uncertainties. Deflation dynamics no longer at work but the global inflation momentum is rising only gradually and take longer than expected to materialise. We identified an execution risk (at least a delay into 2018) in the expected fiscal stimulus.
- We have a neutral exposure to Japanese equities. Stronger global growth and a supportive domestic policy mix are among the main performance drivers, but a weaker currency is warranted to gain more conviction.
- We maintain an overweight on emerging market equities, with India as our preferred market. They benefit from attractive valuations in a robust global growth context. China should not trigger a systemic risk this year and most recent data (foreign reserves, retail sales, industrial production, loans) are rather supportive.
- We maintain our underweight on bonds and a short duration. With a relatively hawkish Fed and labour market conditions in place to increase inflationary pressures, we expect rates and bond yields to resume their uptrend. The improvement in the European economy could also lead euro zone yields higher as political risks recede and the ECB should start detailing its tapering in the second half.
- We continue to diversify out of low/negative yielding government bonds:
- We have a neutral view on credit, as spreads have already tightened significantly and a potential increase in bond yields could hurt performance.
- We remain positive on inflation-linked bonds as we expect a rise in core inflation by higher wages, less deflationary pressure in China and fiscal easing. Potential US protectionist measures are a wild card.
- We have a slight overweight in emerging market debt as it benefits from strong fundamentals and an attractive carry. Contagion from Brazil to the rest of the emerging markets has been contained.
- We are close to a neutral high yield exposure: the spread compression has exceeded our targets on both sides of the Atlantic, but the carry remains attractive.
- On the currency side, we held a lower underweight on GBP before the British elections.