We have seen an unexpected result in the UK parliamentary elections, continued political unrest in the US and central banks moving slowly towards less stimulative monetary policy despite lower inflation and some diverging macroeconomic data. Despite this, equity markets have still managed to grind higher since we last published the Weekly Strategy Update. However, with equity valuations now at demanding levels, the momentum behind the rally has weakened. One persistent support has been falling bond yields, which has resulted in flatter yield curves.
UK ELECTIONS: AN UNEXPECTED OUTCOME
The failure of the Conservative Party to hold on to a majority in parliament has been mostly visible in the British pound. It had weakened in the weeks up to the elections as the Tories’ lead in the polls over Labour slowly eroded. Since voting day, the pound has fallen by 1.7%. In a pattern not uncommon these days, the main FTSE 100 equity index did well on the heels of the falling pound. UK bond yields briefly spiked higher, but the market quietened down quickly.
The questions now are who will govern in the UK and what does the result mean for the Brexit negotiations with the EU? The Conservatives could still govern, but require support from the Democratic Unionist Party which is socially more conservative and sensitive to the consequences of a ‘hard Brexit’ for the border between its Northern Ireland home base and the UK. Overall, the probability of a ‘hard Brexit’ has fallen, making the depreciation of the pound look somewhat overdone, in our view. We have not taken any position though. We remain short UK equities versus the Eurozone since we believe analyst expectations for UK earnings are too high. If the pound recovers, this should undermine equities and benefit our equity strategy.
FRANCE, ITALY: RISKS FADING
After winning the presidential election, Emmanuel Macron now also appears to be en route for victory in next week’s second round of the French parliamentary elections. With the centre right looking to come in second, this bodes well for structural reforms and should significantly reduce political risk.
In Italy, politicians last week seemed to have agreed on a new electoral law. That would have opened the road to parliamentary elections, possibly as soon as September. With some Eurosceptic parties doing well in the polls, equities had slumped and bond spreads had widened. There was, however, no final agreement and with the results of some local elections showing waning support for the main Eurosceptic party, political risk has faded here too. Italian 10-year yields are back at close to 2%, with spreads over German Bunds narrowing.
CENTRAL BANKS MOVING SLOWLY TOWARDS THE (QE) EXIT
Unsurprisingly, the ECB left its policy rates and asset purchase programme unchanged. The latest ECB staff projections may have been disappointing, with the forecast for core inflation at only 1.7% in 2019, which is clearly below its ‘close to 2%’ target. Still, there were two clear signals that the ECB is preparing to exit its loose, unconventional policy stance: the easing bias in the forward guidance on interest rates was removed and it shifted the balance of risks to the growth outlook to neutral.
We expect the ECB to announce the tapering of asset purchases later this year. This is almost irrespective of the economic data as the ECB has constrained itself as to the assets it can buy. Thus, without tapering, it would run into its effectively self-imposed limits next year. So what could justify any tapering? The ECB said that the current positive cyclical momentum increased the chances of a stronger-than-expected economic upswing, while there are no longer any deflation risks. Still, the ECB would likely be in the (bond) market for a long time as it will reinvest the proceeds of maturing bonds. Whether this suffices to soothe any market worries about tighter monetary conditions remains to be seen. If growth holds up, markets may stay calm, even if the ECB tapers amid low inflation. That is our base case scenario for now.
Looking at the pricing of US fed funds futures, the market is assigning a 95.7% probability to an interest-rate rise by the Federal Reserve this week. The Fed now seems more committed to moving its policy stance closer to a neutral setting, for several reasons. There is now very little slack left in the labour market; at least at the start of the year, inflation appeared to be stronger; financial conditions have not tightened despite the Fed’s rate increases so far and global growth has strengthened; US fiscal policy still presents upside risks to growth and inflation.
However, it must be said that growth was weak in the first quarter and inflation has softened recently to its slowest pace since December 2015. Bond yields have fallen and inflation expectations have come down. Apart from rate rises, several policymakers have shown a preference for trimming the Fed’s QE-bloated balance sheet later this year.
The impact of such measures on yields is uncertain, although upward pressure looks most likely. Especially with the ECB tapering its purchases, yields could drift higher. Hence our structural short duration position. Equity markets may hold up in the short term, but a maturing economic cycle with tighter financial conditions are risks to watch for.
ECONOMIC DATA: US LABOUR MARKET, JAPANESE GROWTH…
In May, the US economy created only 138 000 new jobs, while growth in the previous two months was revised significantly lower. However, indicators such as job openings, voluntary job quits and initial jobless claims still point to a tight labour market. We think the signals that weak orders and capital goods shipments are sending on the prospects for business investment are a more significant reason to be cautious, as is credit growth, which has slowed significantly.
In Japan, GDP growth in the first quarter was revised significantly lower, from 2.2% QoQ annualised to just 1.0%. This looks more negative than it actually is: most of the downward revision was due to inventories. Private consumption growth was revised lower by just a notch and business investment was revised higher. So the economy still looks reasonably strong. The Economy Watchers’ Survey and consumer confidence have trended higher recently.
Trade data in China came in better than expected in May, with exports rising by 8.7% YoY and imports by 14.8%, but the trend in exports and imports does not look very strong to us. And the monetary authorities have been tightening policy, especially for the shadow banking system, sending interbank interest rates higher, which has affected credit growth and may hurt smaller banks. Slower credit growth would be positive in the long run, but to find the right balance between economic growth and credit growth in the short term is tricky, to say the least.
Elsewhere in Asia, trade growth seems to have peaked in South Korea and Taiwan. We look at these countries in particular given their cyclical economies and high exposure to regional and global growth. We think the export growth slowdown ties in with the slowdown in inflation in several Asian countries, which is casting doubt on the reflation narrative, in our view.
ASSET ALLOCATION: EQUITY UNDERWEIGHT CLOSED AND REAL ESTATE ROTATED
Our long-standing equity underweight has been a drag on performance, although at several points, we hedged it with options strategies. Anyway, our fundamental views on equities have not changed. We think equities are expensive, especially so in the US. On several current valuation measures, US valuations are more than one standard deviation above their five-year or long-term average. Equities are priced for a very positive growth and inflation scenario. However, markets have ignored valuations and have continued to move higher. Upward revisions to earnings estimates have been supportive, but we think that earnings expectations are high, especially in the UK. So we have kept our underweight in UK equities versus the Eurozone. We are now neutral the US and Japan and overweight the Eurozone.
In real estate, we have taken profits on our overweight in Europe since Eurozone real estate now looks expensive versus its net asset value. In the US, valuations look attractive and demand should continue to improve given the robust labour market and other demand indicators. New supply is limited, which should also benefit the asset class. Higher interest rates are a risk, but given the positive factors just mentioned, we are willing to take this risk.
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