After a stormy summer, with tough typhoons, monsoons and hurricanes hitting the headlines, the annual Jackson Hole meeting of leading central bankers was more of a storm in a tea cup. ECB president Draghi did not deliver any critical announcement on quantitative easing (QE) tapering and US Federal Reserve chair Yellen did not surprise financial markets either. The two preeminent central banks thus remain cautious on any tightening of their monetary policies as weak inflation data remains a concern on both side of the Atlantic. In the eurozone, encouraging economic data entails a strengthening of the euro that could backfire as it hurts exports, hence the ECB’s hesitation to talk aggressively about tapering now. This week’s regular policy meeting of the ECB’s governing council may well turn out to be another non-event, with new policy announcements only likely later in the year. In the US, the string of disappointing inflation numbers appears to be delaying the next interest-rate rise and the start of balance sheet unwinding by the Fed.
Economic data: improving eurozone, but not ready for taper yet
As said, eurozone fundamentals have been improving so far this year. Growth is strengthening. Soft (survey) data has also been quite positive. The eurozone’s August economic confidence index surprised to the upside at 111.9, marking its highest reading since 2007 (see chart).
Amid a brighter economic environment, inflation has accelerated. Granted, at 1.2%, inflation is still below the official ECB target, but the positive dynamic in core inflation could soon encourage the central bank to announce measures to taper QE. The currency market has front-run any such ECB announcement, causing the European single currency to gain 14% on the US dollar so far this year. This adjustment has now become a roadblock for the ECB, leaving it hesitant to taper its QE programme. Despite of the improving fundamentals, president Draghi appears to not want to give the euro another boost, lest inflation slows again.
The UK-EU negotiations on Brexit appear to be becoming more sensible so as to avoid a cliff edge effect. The British government, weakened by the results of the June snap elections, now has less legitimacy to impose a hard Brexit and is looking for compromises. Negotiations may gain further momentum after the German general elections on 24 September.
On the economic data front, the clouds appear to be lifting as well: the manufacturing PMI reached its highest level in four months at 56.9 in August.
EM goldilocks: is it sustainable?
Emerging markets have been benefiting from the current environment, rendering our position on EM local debt profitable. The weak US dollar has been a strong driver of emerging market performance, while low inflation in the US has benefited EM as it appears to postpone any further rate rises by the Fed, leaving interest rates lower for longer. Robust soft (survey) and hard data have contributed to the gains, with strong demand driving industrial metals prices to expensive levels (see chart). So, emerging markets have benefited from this improving macroeconomic backdrop and the relatively weak USD, but we are wondering whether this is a sustainable trend.
In our view, the critical risks are now a stronger USD if US inflation starts to reaccelerate and forces the Fed to act more quickly on raising rates and unwinding its balance sheet. This could put an abrupt end to the strong EM performance. Another risk to monitor is the likely end of China’s stimulus efforts post the national party congress this autumn.
Asset allocation: overweight US dollar; taking profits on EM dollar debt
In currencies, we are maintaining our long US dollar position versus the euro. This is a long-term, high-conviction trade.
Improving fundamentals and less political risk than earlier this year have been positive for the euro. On the other hand, while the US dollar has remained weak, most of the bad news now seems to be priced in. The USD could rebound sooner rather than later as market participants are discounting weak data in the US, while expressing positive views on the eurozone.
A relatively minor change in the outlook could induce a reassessment and a repricing. The apparent peak in the eurozone PMI could signal an upcoming change in market sentiment. On currencies, we remain bearish on the euro and have a short position.
In fixed income, we have closed our neutral tactical position. We took profits on our tactical duration position before the Jackson Hole meeting and have returned our strategic underweight duration position, particularly in European bonds, as we expect the ECB to be one of the first major central banks to adopt a less symmetrical reaction function and place greater emphasis on prudent management of financial markets.
As for our other strategies, we regard US equities as more overvalued than European ones. We are overweight eurozone equities versus US and UK equities. This also reflects the fact that our forecasts for UK corporate earnings are much lower than consensus expectations and, as such, we expect UK equities to underperform those in most other major equity markets.
On real estate, European stocks have rallied significantly this year, while US real estate has lagged. This encourages us to maintain our overweight in US real estate as we expect this divergence to reverse over the coming months amid a pick-up in demand for US real estate.
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