Strategy: With a US hike baked in, investors ask where the heat is in Europe

22 Nov 2016

  • US growth set to accelerate this quarter
  • Is the US Federal Reserve becoming more hawkish?
  • Political risks linger in the eurozone
  • Trade data still looks weak

After quickly pricing in a brighter growth and inflation story in the US and to some extent in the eurozone, but higher risks for emerging markets right after the US elections, financial markets calmed down in the past week. US 10-year bond yields rose further, but risk spreads on high-yield corporate debt fell. In Europe, German Bund yields retreated, while spreads on investment-grade and high-yield corporate bonds widened further. Italian bonds remained under pressure, partly because markets now appear to be making a sharper distinction between a pro-growth story in the US and a riskier outlook for the eurozone. Yields on emerging market (EM) debt are still high, while most EM currencies remain under pressure.


Ahead of this month’s elections, the increased uncertainty did not hold back US consumers. Retail sales rose by a strong 0.8% MoM in October after a 1% jump in September. The annual growth rate almost doubled from 2.2% YoY in August to 4.3% in October. Is such strong growth sustainable? Nominal average hourly earnings for all employees grew by 2.8% YoY in October, the fastest pace since mid-2009. Subtracting inflation leaves real wage growth of just below 1.5%. But employment is also increasing and a wage tracker by the Atlanta Fed rose by 3.9% YoY in October. All in all, we believe consumption is set to accelerate this quarter.

Residential investment may also be supportive of GDP growth in this quarter after having been a drag for two quarters. Housing starts surged by 25.5% MoM in October, mainly driven by multi-family unit starts. This came after two weak months, but it is still the highest level since August 2007. Building permits confirmed the bounce in the housing market. The steep recent rise in bond yields and mortgage rates poses a risk though.

The improvement in the data has been picked up by the Atlanta Fed’s GDPNow index, which currently forecasts 3.6% QoQ annualised GDP growth in the current quarter. With consumption likely to moderate from October’s fast pace in our view and strong headwinds from net trade still to come (a surge in soybean exports in the third quarter should turn into a drag), we would not take any nowcasting index too literally at this point.

Nevertheless, we believe the US Federal Reserve is on course to hike interest rates in December. In testimony before the US Congress, Chair Yellen said that the economy had made further progress toward the Fed’s dual mandate of maximum employment and price stability. In a nod to a drop in the natural fed funds rate, Yellen acknowledged that current monetary policy is only moderately accommodative. In our view, that points to a gradual pace of rate rises in this cycle. Mentioning that the FOMC in its early-November meeting judged that the case for a rate rise had continued to strengthen, Yellen clearly hinted at a December hike. She warned that if the Fed delayed any rate rises for too long, it could end up having to tighten policy relatively abruptly later on. It looks like the Fed is slowly becoming more hawkish. This fits with the theme of rising rates and yields that had gripped markets even before the US elections.


Growth in the eurozone was steady in the third quarter at 1.6% YoY. France returned to positive territory and growth in Italy accelerated, while growth in the Dutch economy was stronger than in any of the bigger member states. Leading indicators such as the Economic Sentiment Index, the PMIs and the German Ifo index point to stable growth at least, if not some acceleration. So growth is not our main concern for the eurozone at this point.

Political events in France and Italy are to be watched closely. Reform-minded Francois Fillon won the first round of France’s conservative primary for the party’s presidential candidate. But it is still a long way to next year’s elections, with the next hurdle being a runoff against number two Alain Juppe. Another upcoming event is the Italian referendum on 4 December. Prime Minister Renzi has said that he would resign if he lost the vote. Given where the polls are now and the recent widening of Italian government bond spreads versus German and Spanish bonds, markets may now have discounted a No vote. A rejection could still cause a shock.


October data from the six early reporting emerging markets we track to get timely signals on trade shows exports fell in Brazil, Chile and China. South Korea saw modest gains and Taiwan and India posted strong gains. Adding it all up, exports fell by 4.5% YoY in US dollars, but rose by 0.3% when excluding China. The numbers do not point to a pick-up in global trade.

We have changed our view on China somewhat. We think that the economy is growing at above potential. Inflation may be turning, although we see a bigger risk of bubbles than of traditional inflation. However, we also think that ahead of the National Congress next autumn, the authorities’ drive to stabilise the economy will become even stronger. One way to achieve this is a weaker currency. The Chinese renminbi is now at its weakest since mid-2008. Whether it will support growth much is questionable. The economy has become less dependent on trade in recent years, foreign demand may be more important than relative prices and much of the recent weakness against the US dollar is actually dollar strength.

On monetary policy, Mexico raised the policy rate by an expected 50bp to 5.25% after the recent weakness and volatility in the Mexican peso. Following the US elections and the related uncertainty, the prospects for business investment have weakened. If the Fed raises US interest rates in December, the Mexican central bank may follow suit.

In Indonesia the central bank left policy rates unchanged, but cut its growth forecast after GDP growth slipped to 5.0% YoY in the third quarter. Weak loan growth and rising bad loans are risks for the economy, but an acceleration in exports is positive. Having cut rates twice in the past six months, the central bank may wait for lower inflation before taking further action.


We have reduced our underweight since we now see the global economic cycle at neutral instead of negative and we have upgraded our view on company earnings from negative to neutral. We would not fully neutralise our equity exposure given the still lingering economic and political risks, but we have selectively added to our exposure. Given our preference for US small caps, we are increasing our overweight in this asset class, expecting US small caps to gain from possible tax cuts and to be relatively well-shielded from any protectionist policies. Even though small caps had outperformed large caps right after the US elections, we still see some value in this strategy. For clients who are restricted in investing in US small caps, we have bought European small caps.


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