Politics have dominated on several fronts, with financial markets relieved as Emmanuel Macron leads the polls for the second round of the French presidential election, a snap general election having been called in the UK and the Trump administration flagging up a major announcement on tax reform. In our asset allocation, we implemented an underweight in UK equities versus European equities. This changes our positioning in Europe from underweight to slightly overweight. We are still underweight equities in the US and Japan.
FRENCH PRESIDENTIAL ELECTIONS: EN MARCHE!
With Macron clearly leading Le Pen in the polls for the second round, markets were relieved. This started in Asia, where the Japanese yen – often seen as a safe-haven currency – depreciated, sending Japanese equities higher. The gains in Europe have so far been even stronger. Banks are leading the way in France and in the EuroStoxx 50. Bond yields are rising in safe-haven countries including the US, Germany, the Netherlands and Switzerland. Falling risk premiums are dominating in France, Italy and Spain, where yields are down. The euro has jumped markedly against the US dollar and the British pound.
We think Macron’s prospects for the second round look positive. There may be some market volatility between now and the second round result being announced on 7 May if investors continue to fret about whether Eurosceptic Le Pen can win. What Macron could deliver on the domestic front as president is unclear as it will depend on the nature of the Parliament he has to deal with.
PARLIAMENTARY ELECTIONS IN THE UK: TOWARDS A HARD OR A SOFT BREXIT?
UK Prime Minister Theresa May called a snap election last week, and polls suggest she will win easily. The news was positive for sterling, presumably on the basis that a large parliamentary majority will better enable May to compromise in her negotiations with Europe and deliver a softer Brexit. But some uncertainties remain. The elections may deliver even more ‘hard-Brexit’ Conservative MPs. And the prime minister may start to see a hard Brexit as inevitable, even with a bigger parliamentary majority.
US TAX REFORMS COMING?
President Trump tweeted on Saturday that “Big TAX REFORM AND TAX REDUCTION will be announced next Wednesday”. And while White House OMB Director Mulvaney has said that the Wednesday release will only contain “some specific governing principles, some guidance, also some indication of what rates are going to be”, this could be enough to revive reflationist sentiment in markets. Specifically, the guidance may suggest that tax cuts will increase the deficit in the near term, but the growth they induce will allow the tax plan to pay for itself over time. Still, we caution that some major issues seem not yet to have been ironed out, most importantly whether to focus on simple tax cuts or on comprehensive tax reform. And more immediately there is the looming issue of funding the government and avoiding a shutdown come 29 April. We think tax cuts are unlikely to be enacted until the fourth quarter at the earliest.
WHAT ABOUT ECONOMIC DATA?
Preliminary PMIs showed further gains in the Eurozone in both the manufacturing and services sectors. The composite PMI rose to its strongest level in six years. We are positive on the Eurozone growth outlook, but sceptical that actual GDP growth will accelerate as much as the PMIs indicate. Eurozone exports and imports lost some momentum in February, while industrial production unexpectedly fell.
In the US, both sector indices fell, with the composite falling for the fourth straight month. Regional business sentiment indicators and sentiment among home builders has also disappointed lately. At first sight, industrial production looked okay in March, but the MoM drop in manufacturing production showed underlying weakness. Growth looks to have been very modest in the first quarter and the acceleration in the second may be limited.
In Japan, the manufacturing PMI improved in April after a dip in March. The divergence between the domestic and external sector remains striking. Data on domestic spending is still weak, while exports and imports surged in February. From a domestic growth perspective, stronger growth in imports than in exports is actually negative for the first quarter.
In China, the latest data confirms that the recovery in activity is still very much on track. Chinese GDP increased in the first quarter, as did nominal GDP. There was a marked acceleration in fixed-asset investment. The sectorial split of activity shows a pick-up in the secondary sector, while service sector growth slowed. Stable growth in China is a near-term positive, but we still see some risks. Money growth has slowed and broad bank credit, including credit to the government, even more so. Thus, fiscal and monetary stimulus appear to be wearing off. It remains to be seen how strong the Chinese economy is without stimulus.
US EARNINGS SEASON OFF TO A GOOD START
The US first-quarter earnings season has started well, with a large majority of the 20% of S&P500 companies that have so far reported surprising positively on net income and on sales. For both it is the strongest beat rate in years and, especially in sales, a strong improvement from the past two years when only half of the companies managed to beat sales expectations. Growth of more than 10% in earnings per share in the first quarter, based on the numbers released so far and expectations for companies that have yet to report, would be the strongest pace since the third quarter of 2010. Our problem with US equities lies more in valuations. We think that in a modest growth scenario, the current price-earnings ratio of 17.5 is quite high.
NOW UNDERWEIGHT UK VERSUS EUROPEAN EQUITIES
In our asset allocation, we have implemented a short UK versus European equities position. Depending on client mandates we have moved underweight UK equities versus Europe ex-UK or versus the EuroStoxx 50. There are two main reasons for this trade. Firstly, we wanted to close our underweight in European equities. The relative value trade versus the UK makes us effectively overweight Europe ex-UK equities. This fits with our positive view on the Eurozone economy. We had not been overweight before due to our below-consensus earnings forecasts and somewhat rich valuations. That said, we think valuations are less of a concern in Europe than in the US. But this trade is not just about the Eurozone. We actually think the consensus expectation of 15% earnings growth in the UK is too high. UK earnings have done well due to the decline in the British pound and the improvement in oil prices, but these effects are fading. We actually see no scenario where UK earnings will meet expectations, hence our underweight.
The relative value trade – short UK versus European equities – slightly increases our risk exposure, as we are underweight a more volatile equity index. This is in line with our recent strategy changes, such as the closure of our commodities underweight and the overweight in emerging market debt in local currency. But overall, we are still positioned on the cautious side, with an underweight in developed equities, an underweight in emerging market debt in hard currency and an underweight in US high-yield corporate bonds.