Asset Allocation June 2017

09 Jun 2017

  • Inflation disappoints, but central banks carry on
  • Is growth becoming more domestic?
  • Now closed: underweight in developed equities
  • Overweight real estate rotated from Europe to US
  • Now closed: tactical short Bund duration and long Gilts versus Bunds

Political turmoil in the US, new UK elections, the possibility of early Italian elections and central banks staying the course on monetary policy despite soft inflation numbers could not derail the equity rally, at least in US dollar terms.

With the US dollar losing around 3% versus the euro, global equities were actually down by 1.3% in euros. We think that in general, equity markets are priced for a positive scenario for growth, inflation and earnings. Still, we have neutralised our equity underweight position. In real estate, we have shifted our overweight from Europe to the US.


Inflation has softened recently. In the US, the core CPI fell to 1.9% in April and the core PCE (the US Federal Reserve’s preferred measure) slipped to 1.5%. There were temporary factors at work, but it was still the slowest pace of inflation since December 2015. In the Eurozone, core inflation dropped to 0.9% in May and Japan’s core CPI fell back into deflation in both March and April.

Inflation expectations, as measured by 5-year forward inflation swaps, have come down in the US and the Eurozone. In China, where producer price inflation had surged to 7.8% YoY in February after years of deflation, it slowed to 6.4% in April. Producer prices typically follow commodity prices closely and this time was only slightly different: prices had increased by more than what was explained by commodity prices. Even so, the underlying trend had not been strong. Moreover, core consumer prices rose by just 2.1% in April.

In our view, this shows how difficult it is to create inflation. Even in the US and Japan, where the unemployment rate is close to record lows, wage inflation has been muted. There may be several reasons for this. One is that there is still slack in the economy which limits the extent to which producers can set higher prices or the ability of workers to demand higher wages. But given the shape of the labour markets in the US and Japan, one would expect some wage growth. Perhaps companies do not want to pay higher wages as long as productivity growth is muted. Foreign competition may also be fierce, while domestic competition may have been fired up by internet trading, which has made it so much easier for consumers to compare prices. Anyway, our conclusion is that the reflation story has suffered a setback.

And yet, central banks do not seem to have changed their policies. Some policymakers at the Fed are concerned by the lower inflation and have said that if this persisted, it should have implications for the future path of interest rates. But the majority has stuck to the view that there will be two more rate rises this year. At the May meeting of the Federal Open Market Committee, policymakers agreed to gradually trim the Fed’s balance sheet by setting slowly increasing limits for the amount of debt held by the Fed to roll off. In such an approach the amounts of debt reinvestment the Fed needs to do would gradually decline. According to the minutes of that meeting, nearly all policymakers agreed that, if the economy grows as expected, it should be appropriate to start reducing debt securities holdings this year.

At the ECB, the hawks have ruffled their feathers, but we still think that the bank will first have to establish that the risks it sees for the economy are now balanced. Currently, it sees those risks as tilted to the downside, but ECB president Draghi has acknowledged the outlook is improving. The ECB should also first remove the reference to ‘lower interest rates if needed’. Those changes may come soon, to be followed by an announcement of the tapering of the ECB’s asset purchase. That process may start next year. It may be well into 2018 before we see the first rate rise.

Japan’s BoJ has stuck to its policy of keeping 10-year yields at zero, while in China the crackdown on shadow banking and interest-rate increases have continued.

Lower inflation and central banks in the process of or moving towards gradually removing extraordinary monetary stimulus have not missed their impact on bond markets. Add in political uncertainty in the US, the Eurozone and the Middle East, and it is clear why bond yields have fallen. The US 10-year yield has broken out of its recent trading range to the downside. Germany’s 10-year yield has fallen to the lower end of the range. The spread between two-year and 10-year yields in the US has fallen to below the levels seen before last November’s US presidential election.

Equities have hardly suffered. Perhaps the prospect of a goldilocks scenario with decent growth, low inflation and low interest rates has been enough to keep the rally going. Financials have lagged as a result, although energy did even worse as oil prices fell.


Global PMIs continue to signal a positive outlook for the world economy. Our GDP-weighted composite PMI rose to 53.4 in May, its highest since January 2014. This was driven in particular by the composite PMIs in Eurozone countries. Looking beyond the headlines, we are seeing some subtle changes. Services sectors looked buoyant in most countries for which this data is available, with the exception of Brazil, where the index fell to below 50. But manufacturing PMIs, which are available for a much broader range of countries, slipped marginally in developed economies and emerging markets. China’s official manufacturing PMI held steady after a fall in April, but the Markit manufacturing PMI slipped to below 50, feeding market concerns about the outlook for this country.

Leaving aside the availability of data, a shift from manufacturing to services may have implications. Trade growth, which had accelerated recently and was part of the reflation story, may slow again. There are tentative signs that this is already happening in emerging markets. This could have an impact on industrial production, where growth is typically more cyclical than in the services sector. In the Eurozone the leading indicators are super strong, while tailwinds for the economy such as the sharp drop in energy prices and in the euro in 2014, which supported growth in 2015 and 2017, are fading. In the US employment growth disappointed in May, while orders and shipments of durable goods have basically moved sideways for two months now. We do not want to argue here for a sharp slowdown in global growth, but we do want to warn against overly optimistic views.


In our asset allocation we have closed our equity underweight. This long-standing strategy has obviously been a drag on performance, although at several points we hedged it with options strategies. Anyway, our fundamental views on equities have not changed. We think equities are expensive, especially so in the US. On several current valuation measures, US valuations are more than one standard deviation above their five-year or long-term average. When we look at forward PEs and relate those to nominal or real interest rates, we come to the same conclusion: equities are priced for a very positive growth and inflation scenario. However, markets have ignored valuations and have continued to move higher. Upward revisions to earnings estimates have been supportive.

We think that earnings expectations are high, especially in the UK. So we have kept our underweight in UK equities versus the Eurozone. This strategy did well initially, but uncertainty over the general election and signs of a slowing economy have undermined the British pound, which has actually supported UK equities. In our asset allocation we are now neutral on the US and Japan, overweight the Eurozone and underweight the UK.

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