Asset Allocation February 2017

03 Feb 2017

  • Markets digest policy uncertainty in the US
  • Monetary tapering in 2017?
  • Now underweight US high-yield

After rallying in November and December, equity markets advanced at a slower pace in January. At a global level, equities gained modestly in US dollars. But with the dollar losing some strength against the euro, equities were flat for euro-based investors. This left equities still ahead against other broad asset classes such as global bonds, real estate and commodities. These asset classes saw even smaller gains in US dollars and actual declines in euros. This is not so much due to economic data. Economic surprise indices have rolled over in the US and the eurozone, but we think this is not a result of weaker data. It is because expectations have been catching up. In emerging markets, economic surprises have been extremely positive. Nevertheless, the hurdle for further gains in equities is getting higher, in our view. Expectations are now more elevated and valuations have continued to increase in the US. We have not changed our underweight in developed equities, but we have added an underweight in US high-yield corporate bonds. We think narrowing spreads do not properly reflect the worsening corporate fundamentals.

AFTER THE SUGAR RUSH: THE HANGOVER?

Since November’s US elections, financial markets have focused on the positive elements of President Trump’s agenda. Emerging market currencies have depreciated, but the Mexican peso has plunged. But even in emerging markets the widening of risk spreads on hard-currency debt was short-lived. Markets are counting on a big fiscal package in the US, including income and corporate tax cuts, repatriation of foreign taxes, infrastructure spending and deregulation. The new president has moved quickly on some sectors, particularly energy.

We think many of these ideas have pros and cons. While we do not know the size of the fiscal stimulus, we are assuming it will be significant, but the amount that president Trump would expect. On any income tax cuts, it remains to be seen which income groups will benefit and whether they will spend or save the windfall. Will the
corporate tax cut be unfunded? And if corporate taxes are cut, but companies are no longer allowed to deduct interest-rate expense for tax calculations, what will the net impact be on US companies? How fast can the president move on infrastructure spending and deregulation? We think these are themes for 2018 rather than 2017. So, will the stimulus come at the right time? The US economic cycle is well-advanced and the economy is close to full capacity. Thus, fiscal stimulus could lead to higher inflation and induce the Federal Reserve to raise rates quicker than currently expected in the markets. We cannot rule out a boom-bust scenario.

While the plans mentioned above should work out positively at least in the short run, the administration’s protectionist streak and meddling in individual companies’ decisions is negative, in our view. Some of the administration’s nominations and its temporary travel ban targeting citizens of seven North African and Middle Eastern countries have sent a shock through the equity markets.

Overall, we do not rate the political, tax and regulatory risks as outright negative for equities. Our underweight is primarily driven by stretched valuations and our risk scenarios, which include a hard landing in China, strong global protectionism and rising inflation and bond yields in the US. But politics could be the spark for another selloff. What also concerns us is the low volatility. The VIX index, which measures volatility in the S&P500 equity index, has fallen to its lowest in years. The V2X index for the EURO STOXX50 has trended lower for a year. Volatility in US government bonds is somewhat higher, but we think many investors may be too complacent.

TOWARDS THE END OF QE?

To be clear, we think that the ECB will not renege on its promise to keep quantitative easing (QE) going for the rest of the year at a rate of EUR 60 billion per month. But president Draghi may face some tough question-and-answer sessions after ECB policy meetings. Just look at growth and inflation in the eurozone. In the fourth quarter of 2016, the eurozone economy grew by 0.5% QoQ. This is above the region’s long-term trend growth rate and an acceleration from the (upwardly revised) 0.4% QoQ in the third quarter. Leading indicators have continued to point to strong growth and the credit cycle is slowly gaining traction. Headline inflation jumped to 1.8% YoY in January.

So, while Draghi could face push-back externally as well as within the ECB, he cannot yet declare mission accomplished. Core inflation was unchanged at 0.9% YoY in December and has essentially moved sideways since mid-2015. Total labour costs and unit labour costs do not signal imminent inflationary pressures. Unemployment has trended lower, but is still too high to generate wage pressures. Of course there are regional differences. The German, Spanish and Dutch economies are in a cyclical upswing and France did well in the fourth quarter, but Italy is lagging. A full resolution mechanism for the banking sector has yet to be found and unemployment has increased lately.

In the US much of the discussion has focused on the number of rate rises expected for this year. It seems that the Fed is now leaning towards three increases. The debate about the size of the Fed’s balance sheet has also heated up. Currently the Fed is reinvesting the proceeds from maturing mortgage-backed securities (MBS) and Treasuries bought in several phases of quantitative easing. Thus, its balance sheet – blown up in the years since the financial crisis to USD 4.45 trillion – has held at that level.

Meanwhile the shape of the US economy has improved. At 1.9% QoQ annualised in the fourth quarter, GDP growth missed the market’s modest expectations, mostly due to what is likely to be a temporary drag from net foreign trade. Domestic final demand, which excludes net trade and inventories, accelerated as stronger growth in business investment outweighed the slowdown in consumption. Confidence is high in most sectors

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