Asset Allocation March 2017

07 Mar 2017

  • Markets are ignoring political uncertainty
  • Global economy may struggle to live up to positive leading indicators
  • High earnings expectations
  • Overweight European real estate; duration exposure reduced

Last month I warned of a hangover after the sugar rush that followed the US presidential election. Although there were plenty of event risks in February, the hangover hasn’t come. Leading indicators for the global economy have remained strong and corporate earnings have generally been supportive of equities. What has also helped is that bond yields have hardly reacted to higher inflation and a more hawkish tone from the US Federal Reserve. However, we think that the air is getting thinner for equity markets amid high hopes for earnings and somewhat rich valuations. In our asset allocation we have closed our overweight position in US small caps versus large caps and have implemented an overweight in eurozone real estate versus eurozone government bonds instead.


Equity markets have clearly anticipated a more businessfriendly and expansionary policy in the US. But the first few weeks of the new administration have not been smooth. At 42%, President Trump’s approval ratings are much lower than those for previous presidents right after their inauguration. From Reagan to Obama, early approval ratings ranged from 53% to 63% after their first few days in office. This means that political capital has to be built up before it can be spent.

An attempt to do so was Trump’s first speech before Congress. Here he sounded more presidential than before, but the public did not get more clarity on his plans for tax cuts, infrastructure spending or reforms. According to Trump there will be massive tax cuts for the middle class, the corporate tax rate will be lowered and defence and infrastructure spending will be raised sharply while entitlement spending will be untouched. That would lead to massive fiscal deficits at a time when the deficit is already set to widen and government debt is high.

So will these plans make it through Congress? We cannot be certain at this point and given the anticipation in the markets we would see this as an uncertainty. To underscore the point, confidence among small business owners has risen, even though respondents in the same survey say that business uncertainty has also surged.

In the eurozone the uncertainty has focused on the French elections. With the National Front’s Marine Le Pen seen winning the first round of the presidential election and the surprising outcomes in the Brexit referendum and the US presidential election, French bond spreads versus Germany have widened. Interestingly, other markets have been less worried. French equities have moved much in line with the EURO STOXX 50 equity index. French sovereign credit default swap spreads (essentially the insurance premium for government bonds) have widened, but by less than the yields.

We are not overly worried about the French elections. Independent candidate Emmanuel Macron received a boost recently in the form of support from two influential politicians. In the polls he has moved ahead of François Fillon, who has vowed to carry on campaigning for the presidency even though he will be under juridical investigations for alleged fake jobs for his family. In the polls Fillon’s lead over Le Pen has narrowed, but it is still more than 15 percentage points according to most polls, while Macron’s lead over Le Pen in the second round is a robust and fairly stable 20 plus percentage points. But could the polls be wrong again as Brexit and the US presidential election have shown? Sure, but the margins in the US and the UK were much narrower than in France for the second round vote. Moreover, the polls in the US were not wrong in the sense that Hillary Clinton won the popular vote.

We are actually more worried about events in Italy than in France. We think the probability of a euro-sceptic party winning the elections in Italy is higher than in France. Moreover, Italy’s economy is lagging: growth has so far been too low to even stabilise the government debt ratio. The ECB’s asset purchases have suppressed Italian yields, in our view, but tapering the purchases – not on the agenda for now, we think – could change this.


The economy is positive for equities, right? Yes, when you look at recent leading indicators. Our global GDPweighted manufacturing PMI looks set to have held at a relatively strong level in February (some countries have yet to report). In February, the US ISM manufacturing index jumped to its highest since August 2014. In the eurozone the PMIs gained further in February, while the Economic Sentiment Index managed to rise by another notch and trade data from selected emerging markets showed signs of improvement. Yet headwinds are also developing. One of them is the rise in energy prices. Oil prices have almost doubled from their lows, boosting headline inflation. While it may look as if inflation is finally taking off after massive pump-priming efforts by leading central banks, this is not the type of inflation we have been waiting for eagerly. With low nominal GDP growth and low nominal wage growth, higher inflation is crimping consumer spending. In the US real disposable income fell by 0.2% MoM In January, cutting the annual growth rate to 2.0%.

In Japan and the eurozone real wages are falling as well. Employment growth adds some room for spending growth, but the pace may fall in the near term. Furthermore, the US economy has to cope with a strong US dollar. If the new administration goes for a Border Adjustment Tax, which would no longer tax exports, but would tax imports, the dollar could strengthen even further. In addition, the bank credit cycle has weakened lately. We are positive on the eurozone economy, where business investment has ample room to grow and employment can fall further. We are more neutral on the US, which is much more advanced in the cycle.

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