Asset Allocation January 2017

12 Jan 2017

  • Stronger growth and inflation…
  • but no need for central banks to react quickly
  • Equity markets have risen too quickly

Stronger economic data and rising inflation: will central banks become soon more hawkish? Markets do not appear to be convinced. Equity markets continued their positive streak and 10-year government bond yields retreated. We are positive on the European economy, but find it hard to see what could cause US growth to accelerate. So we are wary of chasing the equity rally as we think equities are becoming priced for perfection, while risks are still looming. After we reduced our equity underweight – by adding to our overweight in small caps – in November, we have now diversified our equity underweight. Instead of being underweight just in Europe, we are now underweight in the US, Europe and Japan.

POSITIVE SURPRISES

Economic surprise indices have turned positive and look quite strong in the US, Europe and emerging economies. In Japan they have retreated somewhat.

What is driving these changes? We think it is mainly survey data. Purchasing managers indices (PMIs) have continued their uptrend. The improvement in the Markit PMIs was modest in December. Our global GDPweighted composite PMI, which measures activity in the manufacturing and services sectors, increased by just a notch from 53.3 in November to 53.4 in December. In developed economies the index was unchanged at 54.1, while it rose by 0.2 points to 51.8 in emerging economies. This may look lacklustre, but these are the highest readings since late 2015 for developed economies and since late 2014 for emerging markets.

So while this data points to improved economic momentum, it also shows that emerging economies are lagging. This is even more so in the manufacturing sector. While the average manufacturing PMI for developed economies surged to 54.4, in emerging market it rose to only 51.0. For both regions this is a clear improvement from six months ago, but the gap between developed and emerging countries is the widest in more than a year. While developed and emerging economies’ PMIs tended to be more aligned – or PMIs were higher in emerging economies – up to 2013, manufacturing PMIs have been consistently higher in developed economies since then.

In the US the ISM manufacturing and non-manufacturing indices have improved further, while consumer confidence, homebuilders’ confidence and confidence among small business owners have surged. This is not just due to the end of any uncertainty over the election results, but also because of hopes of personal and corporate tax cuts and increased spending on infrastructure. Consumers, for example, have become more optimistic on their income outlook.

In the eurozone the Economic Sentiment Index jumped to its highest since 2007, with strong gains in Germany, France, the Netherlands and Belgium, but weakness in Spain and Italy. Spain should be less of a problem since growth has been strong and may just be moderating. In Italy the surveys may be adjusting to stagnant growth data after earlier optimism. In Germany the Ifo index rose to its highest in almost two years, pointing to a booming economy.

BUT WHAT WILL DRIVE GROWTH?

It’s a strong signal that sentiment indicators are improving across such a broad range, but frankly, such hopes are not always fulfilled. We find it easiest to see a continuation of above-trend growth in the eurozone. There is still ample slack in the economy with the unemployment rate at 9.8% and business investment at a low level relative to GDP. Employment growth should support the domestic economy as well as low interest rates and the relatively cheap euro on a purchasing power basis.

For the US we find it harder to see faster growth. The labour market is showing signs of full employment as hourly earnings growth is accelerating, but employment growth is slowing gradually. As a result, nominal income growth has slowed marginally, but with inflation increasing, the impact has been more noticeable in real disposable income growth, which had receded to 2.3% YoY in November. This sets a speed limit on consumption growth unless consumers are now optimistic enough to lower their savings rate. After several years of deleveraging there is room for consumers to dip into their savings, but we think the financial crisis has made US consumers niftier. Moreover, pension shortfalls require a decent saving rate.

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