Equities continue to run, but bumps in the road remain

Risks present hurdles for US high-yield credit and EM USD debt

20 Feb 2017

  • How will the US cope with higher inflation?
  • Positive on eurozone despite small setback
  • Hopes rise for corporate earnings

Positive economic data and improved corporate earnings have continued to push equities generally higher. Even relatively hawkish testimony by Janet Yellen, chair of the US Federal Reserve, put hardly a dent in this uptrend. It seems to confirm that the reflation trade, which should result in higher growth, higher inflation and higher corporate profits, is the best position for many investors to be in. We do not agree. We think equities are somewhat richly valued and that market volatility is extremely low given the pervasive political and economic risks. We have not changed our cautious asset allocation.



Overall, the latest numbers point to an economy that may be starting to generate some inflation. Retail sales in January jumped by 5.6%, the fastest pace since March 2012. Stripping out components that do not go into the consumer spending data for the calculation of GDP, core retail sales grew at a slower 4.0% YoY, which is still the fastest pace in two years.

One of the differences between headline and core sales is petrol sales, which were up by 14.2% YoY due to higher crude oil prices. So that is one headwind for consumers in the US (and not just the US). West Texas Intermediate (WTI) oil prices have surged by just over 80% in a year, which has had a profound impact on inflation. But core inflation is up only marginally. US inflation has also been driven by higher housing costs. The impact on wages is clearly visible, so we do not foresee sustainably higher growth of private consumption.

Will companies take over the baton? Actual industrial production fell in January from December. Annual production growth was flat, which is an improvement from the declines in most of 2016, but far from strong. Manufacturing output, excluding mining and utilities, is growing marginally better, but capacity utilisation has been below its long-term average since the financial crisis. So the need for companies to invest is limited, in our view.

Some of the new administration’s proposals on corporate taxes, deregulation and repatriation of corporate profits may turn out to be beneficial, but uncertainty is high and companies may choose to wait and see. In the housing market homebuilders’ confidence has slipped, but activity seems to have picked up.

What does this mean for the Fed? In her latest speech, Fed chair Yellen was hawkish, pointing to the risk of letting the economy run hot eventually resulting in the need to raise interest rates rapidly. She said the Federal Open Market Committee (FOMC) would assess whether employment and inflation were continuing to develop in line with the Fed’s expectations and whether further adjustments of the federal funds rate were appropriate. This is not a definitive signal that rates will rise in March, but we believe the option is certainly on the table. The probability of a March hike currently discounted by fed funds futures is 32%. What could hold back the Fed is political uncertainty. But markets could also question the Fed’s intention of gradual rate hikes if it moved again in March, three months after raising rates in December.

Interestingly, US equity markets were not scared by Yellen’s comments, even though 10-year Treasury yields rose by a couple of basis points. We take it that markets were emboldened in their faith in the reflation trade. We think some complacency has entered perceptions here.



At 0.4% QoQ in the fourth quarter of last year, GDP growth came in a notch below market expectations. This pace is still above the long-term sustainable trend and therefore high enough to lower unemployment. German GDP growth also fell slightly short of expectations and third-quarter growth was revised down by a notch. Growth was lower in France and Italy YoY, even though French growth accelerated on a quarterly basis. Growth in the Netherlands was strong.

With these data we do not see a need to change our positive outlook for the eurozone. Rising energy prices may be a headwind, but higher taxes on energy tend to damp the impact on spending compared with the US. The currency is not a headwind and the credit cycle is improving marginally. At and around the ECB the hawks continue to push for less monetary accommodation, but with core inflation far below the target, we expect the ECB to be patient.

In the UK we may be seeing signs of the impact of the Brexit decision on the economy. Consumer confidence is now weaker than before last June’s referendum. Employment has lost some steam. The YoY growth rate of retail sales slowed sharply in January. House price gains are slowing. The weak pound and higher oil prices have lifted inflation, creating a tough choice for the Bank of England: raise rates to stem inflation or keep policy accommodative to support growth? Overnight Index Swaps signal a rate rise this year is only a marginal probability.


The Q4 company reporting season is ending and our conclusion is that it was positive overall. Revenues reported so far have grown by 4.8% YoY and net income is up by 5.6%. Earnings per share are on track for 7.3% YoY growth. The recovery in revenues and earnings which had started early in 2016 continued throughout last year. Sectors that stand out in terms of net income growth are utilities, financials and information technology.

Earnings momentum – the three-month change in 12-month forward earning expectations – turned positive last June and was strong from August to January, but slipped in February. It looks like most of the upward earnings revisions have now been made.



The earnings season is halfway in Europe and so far it looks less strong than in the US: 62% of companies have surprised positively on revenues and 52% on net income. This marks an improvement on the revenue side, but net income beats have so far dropped back to their longer-term average. Earnings momentum has turned more positive than in the US.



We are underweight equities, US high-yield corporate bonds and emerging market debt in US dollars. For the last two asset classes we think that the rewards from the carry are not enough to compensate for the risks of higher spreads or rising underlying yields. We are underweight commodities since we do not see much further upside potential for prices, while the carry on crude oil is negative.




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