It is onwards and sideways – for now!

Asset allocation holds steady amid lack of triggers

15 May 2017

  • Weak US inflation should be no reason for the Fed to pause
  • UK economy slowing, limiting scope for BoE hawkishness
  • Chinese economy follows PMIs down
  • Asset allocation unchanged in mainly directionless markets

US equity markets have lacked a catalyst for change from the sideways trading since late April. It looks like the more volatile political environment no longer surprises the markets. Mixed economic data have been offset by strong company earnings. Bond yields have no clear direction either. In the eurozone, earnings and the economy look quite positive, although recent soft data would seem overly optimistic. After two strong weeks, equities have paused, but investor concerns over the outlook for China have remained. In this environment, we have left our asset allocation unchanged.


One disappointing data point may be just a blip, but two may mark the start of a trend. US core inflation was weak in March and April and the details of the latest report were not encouraging. Consecutive weak months should depress annual readings for the remainder of the year and the overall breadth of the weakness suggests inflation may be on a softer trend. The Federal Reserve has said that it will regard the weakness in first-quarter GDP growth data as transitory, but will the back-to-back weakness in core inflation give it any reason to pause the gradual tightening? After all, this weakness should carry over into the Fed’s preferred inflation gauge and could keep it from reaching the 1.8% rate the Fed has projected for the end of the year.

The Fed expects diminishing slack in the US labour markets to eventually spark (wage) inflation. If it doesn’t, it will likely further lower its estimates of the unemployment rate at which inflation will pick up, or blame its resilience on global factors. Anyway, both would imply an even more gradual pace of rate rises. But for now, we are not changing our view that the Fed will raise interest rates again in June. Market expectations for a June rate rise have remained at close to 100%. We think the Fed is still looking for opportunities to raise rates to gain more room to manoeuvre with its main monetary policy tool. It may have taken some comfort from a rebound in retail sales in April and the upward revision to the February and March data.


After industrial production in the eurozone fell for the second straight month, there is yet more evidence of a disconnect between hard (real economy) and soft (survey) data. In truth, the weakness in industrial production in March reflected the mild weather, which depressed activity in the energy sector. One of the few bright spots was France, where after a dismal run of data, production rose. A fall in production in Germany came after two strong months. In the Netherlands and Spain, annual growth has trended down significantly. In general, market expectations for growth in the eurozone are still high. We are positive too, but we are also concerned that the stellar soft data will not translate into hard GDP data.

In the UK, we are concerned about a growth slowdown after industrial and manufacturing production fell for three consecutive months. The next release of services data is looking ever more important. At the very least, it looks like growth could slow further in Q2. This may have implications for monetary policy. Some investors saw the latest Bank of England inflation report as hawkish after it said that if the central projection played out, one rate rise over the next three years would not be deemed sufficient. This sounds like a statement of the obvious. If everything goes well over the next few years – wages pick up significantly, demand does not slow further and the Brexit talks allow for a smooth transition – policy will be tightened gradually. However, slowing growth and ample uncertainties around the Brexit negotiations do not create an environment for strong wage growth, or higher rates for that matter. Finally, the one central banker who has voted for a rate rise is set to leave at the end of June.


In China, there seems to be no disconnect between hard and soft data, at least not when it comes to the purchasing managers’ indices (PMIs). In April, all four PMIs fell, on average to the slowest pace in seven months. So to us, it looks like GDP growth has peaked amid monetary tightening. Markets have taken notice: 10-year bond yields have fallen to below five-year yields for the first time. Chinese equities are down by 6% from their April peak. We do not foresee an imminent plunge in the economy. But the slowdown does impact our thinking about the global economy and emerging markets in particular. It keeps us from overweighting emerging equities. In fact, we are more inclined to look at hedges for our emerging market exposure.


Markets seem to lack a clear spark for change. The earnings reporting season has mostly been discounted by now. Especially in the US, equity markets have ignored the slower earnings momentum. In Europe, the rally may run further on a stronger earnings momentum as well as the positive economic cycle and supportive monetary policy. As said, we are becoming more worried about the shape of the UK economy, while consensus expectations for earnings look too high. So we remain cautious on developed equities, preferring the eurozone.

Energy prices continue to impact short-term trends. Oil has risen in recent days due to a drawdown of US inventories which has been larger than normal at this time of the year. And OPEC seems willing to prolong the existing production limits. Even so, at close to USD 52 per barrel, oil is back in the range it was in late last year. While we are turning more constructive on oil prices in the longer term, the negative carry is keeping us from an overweight position.

Bond markets have lacked excitement too. US yields in particular have moved in a narrow range this year. German yields have been relatively more volatile, but without any clear direction. In the longer term, we favour short duration positions as growth slowly absorbs the slack in developed economies. In Europe, the rise in the German Bund yield since mid-April was matched by sharply lower spreads on investment-grade and high-yield corporate bonds, but only in the high-yield segment has this led to lower yields. US yields have been quite stable.

We think in general, corporate bonds face a credit risk when growth slows and an interest-rate risk when growth accelerates. So, the risk-reward trade-off does not look positive. However, in the absence of a catalyst, we would not short the asset class given the carry. We are only short US high-yield bonds because the worsening of corporate fundamentals has not been reflected properly in yields, in our view.

We are overweight European real estate versus Bunds. The trade, which we see partly as a hedge against our cautious asset allocation, has done well. We are closely monitoring it to see if we should lock in profits, but for now, we do not see a clear alternative to this position.


Please note that this article can contain technical language. For this reason, it is not recommended to readers without professional investment experience.

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