Can brighter sentiment translate into lasting upside?

Strategy: extending the equities underweight

19 Dec 2016

This is our final Weekly Strategy Update for 2016. We thank you all for your interest in this publication and for your feedback and questions. We wish you Happy Holidays and all the best for 2017. Our next Weekly Strategy Update will be published in the second week of January.


  • Disparity between survey and real data
  • Federal Reserve raises US rates, takes a slightly hawkish tone
  • Asset allocation: equity underweight now includes US and Japan

The rally in developed equities has continued, although we have also seen some profit-taking. That makes sense given how far the move up has gone. In economic data we have seen some divergence between forward-looking indicators and real data. So, are the leading indicators too optimistic or will we see accelerated growth? We are cautious on the near-term growth outlook as we do not see fundamental drivers for an acceleration. We also think that a positive scenario for equities, including growth, low inflation and still stimulative monetary policy is widely discounted. We are holding on to our equity underweight, but no longer have a regional preference: we have diversified our position to a broad underweight in developed equities.


Sentiment data continued to come in positively. The Empire Manufacturing index, measuring confidence among producers in the New York region, jumped firmly into positive territory. The Philly Fed index for the Philadelphia region shot to its highest since late 2014. The national Markit manufacturing PMI now indicates decent growth. Small business owners’ confidence has risen, also pointing to a tightening labour market. Confidence among homebuilders jumped to its highest since July 2005.

Real data has hardly echoed all this positive news. Consumers have become more optimistic, but retail sales growth slowed significantly, possibly because of higher inflation eating into disposable income. Some further moderation in consumption may be in the cards. The surge in homebuilders’ confidence clearly reflects the election outcome. But hard data on housing construction has moved sideways for more than a year. For now, buyers may rush to still benefit from historically low mortgage rates, but the recent surge in rates will be a headwind for the housing market and that would affect consumer spending. So overall, we think the sentiment indicators reflect too much optimism about expected tax cuts, fiscal spending plans and possible deregulation.

Actually, financial conditions have not tightened as narrowing credit spreads, particularly in high-yield corporate bonds, and the rally in equities have compensated for rising government bond yields, higher mortgage rates and a stronger US dollar. Our main point is that the US economy is in the late stages of the businesscycle and that we do not see strong drivers for an acceleration in growth. A pickup in business investment could be a positive surprise, but new orders for capital goods have risen only marginally and shipments of capital goods have fallen. Another fading dragmay be the inventory-adjustment cycle, which has been quite severe.


Among these cross-currents, the Fed increased US interest rates by 25bp to a 0.5% to 0.75% range, as expected, but overall the tone of the Fed was more hawkish. Firstly, the median of policymakers’ forecasts for next year moved up from two rate rises to three. Secondly, Fed chair Yellen dismissed her earlier idea that the Fed wants the economy to run a little hot, i.e. accepting inflation above the Fed’s target.

This actually fits with one of the main themes in our recently published outlook for 2017: we foresee a gradual move away from the super-stimulative monetary policy to gradually less stimulus. In the US we expect two rate rises with a risk that there could be three after all. We do not expect inflation to force the Fed’s hand to tighten more aggressively. The changes in the latest policymakers’ forecasts were actually quite small.


Leading indicators have also continued to improve in the eurozone. The manufacturing PMI rose strongly, while the services sector PMI fell, keeping the composite steady at an above-average level. In Germany the Ifo index continued its strong performance, while the French INSEE index for business confidence jumped to its highest since August 2011.

A sometimes overlooked factor is employment growth. In the third quarter, this was up 1.2% from the year before. With labour costs up 1.5% YoY in the third quarter, income growth should boost domestic consumption. The industrial sector may be a drag on growth in the near term though. Industrial production fell for the second straight month.


Data from Japan and China points to fairly stable economies, obviously growing at different rates, but also somewhat modestly by historical standards. In Japan, there were positive developments in foreign trade. Adjusted for price moves, real exports were actually quite strong, benefiting from the weak yen. But yen weakness also causes consumer spending power to suffer. So overall the impact on the economy is mixed. This may be the reason that the Bank of Japan has let the yield on 10-year government bonds drift slowly to above its zero percent target and that discussions about raising that target have sprung up. Letting rates drift higher or raising the target would hurt the BoJ’s credibility though, so we do not expect a decision on this from the BoJ’s policy meeting later this week.

The range of data from China broadly points to a stabilised economy. The average composite PMI improved to 52.6, which is its highest since November 2013. Industrial production grew by 6.2% YoY, while retail sales growth accelerated to 10.8% YoY in nominal terms and to 8.5% YoY when adjusted for inflation. Fixed asset investment growth was stable at 8.3% YoY, with still most of the contribution to growth coming from building infrastructure. Housing price gains have moderated, although they are still extreme in the biggest cities. With construction at a slower pace than sales, the inventory overhang is gradually being addressed.

There are some risks and headwinds though. The first is that credit growth has remained uncomfortably high in an already highly leveraged economy. We do not see the revival in shadow financing as positive from a financial stability perspective. We think that ahead of the plenum of the Communist Party next year, stability will be given even greater emphasis than usual. But improving imbalances, reigning in the housing market, fading fiscal stimulus and continuing reforms while keeping up growth will be a difficult balancing act. We expect growth to slow next year, with continued discussion and temporary volatility due to rising imbalances.


Markets have taken a lot of positive news in their stride, we think. This is not just about incorporating fiscal stimulus in the US into the outlook, but also better-than-expected data releases. We are constructive on the global economic outlook, but we also see headwinds and therefore do not foresee a strong growth acceleration in the near term. Looking at the fundamental factors for equities, such as economic growth, the outlook for earnings, valuations and monetary policy; we judge them to be broadly negative. We see valuations as the prime negative factor for developed equities. So, we have stuck to our equity underweight. However, we have diversified the underweight from European equities to developed equities, now including the US and Japan. The negative valuation argument is strongest in the US, in our view. Downside risks for equities range from a global demand shock through a hard landing in China or protectionism to rising inflation forcing up bond yields. But that is probably more for 2018.

The relatively hawkish tone from the Fed has pushed US 10-year yields up further. By itself this would mean tightening financial conditions, especially since it is accompanied by a stronger US dollar. But as mentioned, tighter credit spreads and higher equity indices have offset this effect. Since we are not convinced that the Fed will be forced into too much tightening and with the ECB and the BoJ in the market for the whole of 2017, we think bond yields have overshot. So, bond returns may be positive, but we do not see a long duration position as attractive now.

Oil prices have stabilised after the OPEC-driven surge, while copper prices have come down. We are still underweight commodities. We are somewhat sceptical that OPEC and non-OPEC producers collaborating in the recent deal to cut production will fully comply. Given the challenging fiscal situations in many producer countries, the incentive to cheat may be bigger than normal. Furthermore, US shale producers are coming back to the market, so it may take some time for supply and demand to become more balanced. The carry on the asset class is still negative, although that is more of a longer-term argument.