So volatility can still spike, even though it took significant political turmoil in the US to drive it higher recently. And even then the jitters were relatively brief and mainly confined to US markets. Political turmoil in Brazil caused sharp moves in local assets, but since we felt that a 15% sell-off in Brazilian equities in US dollar terms was overdone, we built some short-term positions. Our asset allocation view is still cautious. The modest sell-off seen so far does not change our stance vis-a-vis (developed) equities. This remains one of the asset classes that we expect to have modest or even negative returns. So we are not buying the dips.
POLITICAL TURMOIL HITS MARKETS, IN THE US…
The political climate in Washington turned feverish last week, with some political analysts beginning to speculate openly about a possible impeachment of President Trump. Financial markets became restive. The driver was Trump’s apparent admission that he had fired FBI Director Comey to halt a probe into possible ties between Trump campaign officials and Russia. Markets stabilised – and equities rallied – after the US Justice Department appointed a special – independent – counsel to run the investigation. Investors appeared to see this step as the start of a clear and non-partisan investigation likely to take many months and possibly well over a year. It should serve to lessen any speculation about an immediate impeachment.
In the meantime, though, any tax reform and tax reduction could be delayed and watered down. The probability of a large unfunded tax cut was low anyway, in our view, hence our main economic scenario with modest growth. Uncertainties look set to remain. With the Republican base appearing to be still quite supportive of the president, impeachment is far from a given. And apart from short-term volatility, we do not know what an impeachment trade would look like.
Trades that did well after the presidential election have now given up those gains. On a trade-weighted basis, the US dollar is back to pre-election levels. The yield curve, which steepened initially, has flattened again. Sector-wise, materials and industrials have given up some of their gains and consumer discretionary has weakened lately. So the ‘Trump hope’ has now mostly left the market. But did equities not do well overall? They did, but this performance was supported strongly by a robust information technology sector and, in second place, financials. For now, we would not speculate on any specific outcome, but stick to our fundamental process. This tells us that US equities are expensive and earnings expectations look elevated.
…AND IN BRAZIL
In Brazil, political unrest flared as a news story broke over an alleged corruption scandal said to involve President Temer. Temer denied any wrongdoing and refused to step down. Analysts say Brazil needs to implement tough fiscal reforms to stabilise the level of its debt and the proposed pension reform had been expected to pass in the Lower House before the summer recess. The growing expectation of its passage had anchored a positive cycle in Brazil, marked by reforms, a stable real and a central bank able to cut interest rates and stimulate growth. The question marks over President Temer’s tenure look likely to affect the reform process, but we think the market jitters are overdone given the positive cycle. With the Brazilian Ibovespa equity index off by 10% and the real down by 9% versus the US dollar, local equities have dropped by 20% for a US or European investor. We see this as a buying opportunity and have acted accordingly.
WILL STEADY EUROZONE GROWTH LAST?
Growth in the eurozone was firm at 0.5% in the first quarter, essentially echoing the pace seen since early 2015. While not spectacular, it has been enough to drive down the unemployment rate. And growth now looks more sustainable as it has become more domestically driven. Still, we have some concerns. Can eurozone growth live up to the high levels of its leading indicators? We think it cannot. If the leading indicators are right, growth should accelerate to 3% or 4% YoY from the current 1.7%. We see this as virtually impossible. Also, the regional differences are substantial. In Germany, the economy is now 8.5% above its pre-crisis peak. France, the Netherlands and Belgium have also done well. ‘Peripheral’ countries look much weaker. Italy is only 2.3% above its recession trough and 7.1% below the pre-recession peak.
So what will happen when the ECB starts removing some of its extraordinary stimulus measures? ECB policymakers are split between doves, who point to subdued wage growth and inflationary pressures and overly optimistic ECB projections, and hawks, who tend to focus on the improvement in actual growth and the growth outlook. We expect the ECB to revise the perceived balance of risks from negative to neutral in June and announce in September that it will start tapering its asset purchase programme in January. We expect tapering to take up to September 2018 and only then do we foresee any rate rises.
JAPAN: LOOKING BETTER, BUT NOT GOOD ENOUGH FOR BOJ ACTION
Quite strong first-quarter growth of 2.2% QoQ annualised marked the fifth straight quarter of expansion and the longest growth streak in a decade. Consumption rebounded, although in the absence of any gains in real wages, the trend does not look strong. In fact, there is a dichotomy between strong and supportive net exports and weak domestic demand. Investment growth slowed significantly. The lack of wage growth and core inflation slipping back into negative territory lead us to conclude that the Bank of Japan will continue to target 0% for 10-year yields. As for equities, we think valuations look relatively low and the earnings outlook and recent earnings momentum are also favourable. Monetary policy should stay supportive, but we see the yen holding at around its current level over the next 12 months. Meanwhile, Japanese equities have moved ahead of the currency, so we are reluctant to increase our allocation.
ASSET ALLOCATION: BUY THE DIP IN BRAZIL
As said, we have bought Brazilian equities, but the recent dip in equities was generally modest and US and emerging markets have recovered. We have left our other strategies unchanged.
Surprisingly perhaps, the British pound has been weak despite the strength in the latest labour market and retail sales data and higher inflation. It appears that markets are coming around to the view that the economy is actually weakening. Thus, the prospect of a more dovish Bank of England, especially given the uncertainties around the Brexit process, has led to a flatter yield curve. The probability of an official interest rate rise by the end of the year as discounted by Overnight Index Swaps is now at just below 20%. The weakness in the pound has supported equities and is negative for our relative underweight in UK versus eurozone equities. But we still think that earnings expectations in the UK are way too high and have not changed the position.
We took profits on our long UK gilts versus Bunds position. One rationale for this trade was that eurozone growth could lead to higher inflation, pushing German 10-year yields up (and prices down), while we were concerned about the implications of Brexit for the UK economy. Our view has shifted. We now have concerns about growth (expectations) in the eurozone, while inflation has remained subdued. As said, the markets have picked up on the recent negative surprises in UK data. We also think that Bunds are somewhat more overvalued than gilts. In this context, the yield premium of gilts over Bunds shifted in our favour. With the risks of a reversal rising, we have closed the position.
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