Strategy: Upbeat mood prevails as 2017 starts despite inflation pressures

09 Jan 2017

  • Leading indicators improve further
  • Will late-cycle US economy prevent growth acceleration?
  • Inflation should not concern ECB
  • Equity valuations on the high side

Equity markets have generally remained in a positive mood as economic data continued to be positive, especially leading indicators. Bond yields stopped rising and even retreated somewhat, which helped risk assets. But this also makes us wonder whether bond markets see the world differently from equity markets. We think the economic cycle is now relatively positive in the eurozone, but we are more sceptical about the positive sentiment indicators in the US where higher bond yields and a strong US dollar may pose headwinds. We think any discussion about tapering the ECB’s asset purchases is premature. We still see monetary policy as generally positive for risk assets.

SENTIMENT INDICATORS RETAIN A POSITIVE TONE

Overall, the improvement in the Markit purchasing managers indices (PMI) was modest in December. Our global GDP-weighted composite manufacturing and services PMI increased by just a notch. This may look lacklustre, but the readings are the highest since late 2015 for developed economies and since late 2014 for emerging markets, which shows that emerging economies are lagging. This is even more evident in the manufacturing sector. The gap between developed and emerging countries is now at its widest in more than a year.

At a country level, the Brazilian manufacturing and the services PMIs stayed firmly below the 50 watershed. The economy is struggling with political uncertainty, rising unemployment and a negative credit cycle. Inflation has receded, so Banco do Brasil could well move to cut rates more aggressively. In India, the scrappage of the INR 500 and 1 000 banknotes has dented sentiment, but the slowdown may just be temporary. We think that in emerging countries 50 marks the difference between positive and negative momentum in the economy, not the difference between growth and contraction, as it does in developed economies.

In Turkey the manufacturing PMI has suffered from geopolitical uncertainty. Rising inflation, albeit mainly driven by higher food prices and tax increases, has kept the central bank from easing policy. The weak Turkish lira may even trigger rate rises. The manufacturing PMI lingering below 50 in Indonesia is puzzling. It may improve given the gains in commodity prices. In South Korea the manufacturing PMI is still below 50 amid political unrest.

On a positive note, manufacturing PMIs have advanced strongly in eastern Europe and Russia on the back of stable economic growth in the eurozone and rising oil prices. In China the manufacturing PMI rose to a four-year high and the services PMI shot to its highest since May 2015, but we are finding it difficult to be outright upbeat since improvements are driven significantly by expansionary monetary and fiscal policy. Meanwhile financial imbalances are worsening, the currency has been volatile lately and capital outflow pressure has remained.

In the eurozone the Economic Sentiment Index confirmed our positive view on the region. The index rose by much more than expected, to its highest level since early 2011. The eurozone should benefit from still low interest rates and bond yields and the fall of the euro. A gradually improving labour market has provided domestic support for the economy.

US LABOUR COST PRESSURES

The latest US labour market report showed some deceleration in employment growth, although upward revisions to earlier data compensated for the lower-than-expected job growth. The unemployment rate ticked up as more people started looking for jobs, resulting in a slightly higher participation rate. Including people working part-time for economic reasons and persons who are not looking for jobs, but who have indicated that they want and are available for a job, unemployment fell to its lowest since the 2008/09 recession, but there is still some slack in the labour market. Nevertheless, the economy is approaching full employment. If this is so, we should see faster productivity and hourly earnings growth.

Still, we find it hard to see where faster growth should come from. The housing market has shown signs of peaking and while car sales have jumped to record levels, further strong growth rates look less likely. Household disposable income growth has receded somewhat in real terms, mainly due to higher inflation. With higher prices limited to a few categories, we agree with the Federal Reserve that two to three rate rises should suffice this year.

EUROZONE: A SMALL STEP BACK FROM EXCESSIVELY STRONG NUMBERS

Data in the eurozone and in some member states had been strong, but has now slowed. Retail sales for the region fell, but consumption growth still looks solid and consumer confidence is at its highest since 2007. The unemployment rate stalled and German factory orders have taken a step back, but industrial production accelerated and exports surged. Consumer spending surged in France. Consumption has been on a positive trend for almost two years.

Inflation in the eurozone jumped to 1.1% in December, marking the strongest monthly gain since November 2009. Core inflation, which excludes energy and food prices, ticked up to 0.9%. While we think inflation should not worry the ECB, these numbers will feed the debate about any need to taper the ECB’s asset purchases. The Dutch central bank recently argued for a quick tapering and in Germany, where inflation jumped to 1.7%, calls for tapering may become even louder.

But we think that the ECB will move cautiously. Policymakers should have learned from their mistakes and ECB president Draghi is less hawkish than his predecessor. So, for this year we think that asset purchase programme will not be tampered with. But as we said in our 2017 outlook1, the direction of monetary policy is slowly changing from ever more stimulus to a steady or gradually less stimulative policy. In a positive scenario the eurozone economy should be strong enough by year end for the ECB to taper its asset purchases. If not, the ECB has a problem since the limits to quantitative easing may have become a serious issue by then.

MARKETS IN RISK-ON MODE

Since early November risk assets have been in risk-on mode, on the back of the US election outcome and the prospect of fiscal stimulus through lower income and corporate taxes and higher infrastructure spending, positive economic news and upward earnings revisions.

We think equity markets have gotten ahead of themselves. Our valuation metrics point to equities being on the expensive side, initially in the US and now also the eurozone and Japan. Emerging market equity valuations have improved in Asia and Latin America, but valuations in eastern Europe, the Middle East and Africa have worsened.

Overvaluation of equities is the main reason of our equity underweight. We actually have a neutral view on the earnings outlook globally. We are also cautious due to the downward risks from developments in China, global protectionism or a further rise in inflation and bond yields in the US. We have diversified our equity underweight from Europe to include the US and Japan and cut our underweight by adding to our overweight in US small caps which should benefit from fiscal stimulus and be somewhat insulated from protectionism.

Our duration view is neutral. If president-elect Trump gets what he wants on fiscal stimulus, US bond yields could rise much further. But in an economy which is already close to full capacity, this could lead to higher inflation, faster Fed tightening and a stronger US dollar, which should limit any rise in yields. Record short duration positions in US government bonds should also cap the upside potential. In the eurozone risk spreads on ‘peripheral’ bonds are in the middle of their three-month ranges, except for Portuguese bonds where the ECB is approaching limits. But overall, we think the ECB’s recent extension of its asset purchases should keep a lid on yields. Within government bonds we prefer the US over the eurozone where the risk of rising ‘peripheral’ yields lingers. We like US government bonds mainly for their higher carry.

We think spreads on US high-yield credit may be too low since companies’ balance sheets have deteriorated. For lack of a trigger for spreads to reverse, we remain neutral on credit.

In our total return strategies we have implemented a long position in Spanish equities versus Italian equities. Economic momentum is stronger in Spain and rising house prices should support the housing and banking sectors. Italian house prices are still falling and the banking sector looks more vulnerable. Price-earnings and price-to-book ratios are higher in Spain, but the dividend yield is more attractive. Spain has also made more progress on structural reforms.

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1 See also Beyond the shadow of quantitative easing, the 2017 Investment Outlook by BNP Paribas Investment Partners

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