Strategy: Trundling forward, but unconvincingly

03 Oct 2016

  • Scepticism about OPEC production cut
  • US macroeconomic data improving at the margin
  • Is growth strong enough in the eurozone?
  • Manufacturing PMIs improving, on balance
  • Asset allocation: commodities kept at underweight

News of a possible deal among OPEC members to cut oil production triggered higher oil prices, although this failed to boost equity markets. In Europe, worries about the outlook for banks held back markets. Overall, developed market equities moved broadly sideways, while the emerging market equity rally continue to stall. Ten-year bond yields dropped back to August levels in the US and Germany, reversing mid-September’s yield curve steepening. The Bank of Japan’s new 0% target for 10-year Japanese bond yields led yields in Japan to fall by less than in the US or Germany, but they still drifted below the BoJ’s target. Economic data improved in the US and in manufacturing globally, but was mixed in Europe and Japan.


We are sceptical about the OPEC announcement that it would cut oil output. Some countries – most notably Saudi Arabia – have recently increased their production. For Saudi Arabia, some output reduction would make sense as the current level may not be sustainable and there will be a seasonal cut anyway. While Iran formally agreed to the announced cut, it is actually signing deals to increase production. Iraq and Libya have seen strong growth recently and any political stabilisation in Libya could see production rise further. Non-OPEC member Russia has yet to cooperate. Supply disruptions in Nigeria and Canada have eased, adding to the global oversupply. And higher oil prices could bring US shale producers back to the market more quickly.

We think any deal may be undermined by the reluctance of major producers to give up market share and by the governments in oil-producing countries still having the incentive to produce more oil than agreed so as to sustain their financial commitments. We have kept our underweight in commodities.


After weak growth in H1 2016, the US economy was expected to rebound in the third quarter. While this looks likely, the strength of the rebound may disappoint. The average z-score of several economic surprise indices turned negative in early September and has remained there, meaning the indices are below their long-term average. The weakening of the rebound is also apparent in the Atlanta Fed GDPNow indicator, which shows the current quarter’s GDP growth path based on the latest data. After peaking in early August, this indicator trended down and then slumped last week.

Fortunately, the most recent economic data was better. The September services sector Markit PMI came in stronger than expected, lifting the composite index to a five-month high. Two measures of consumer confidence rose in September; one to a post-recession high. New orders for durable goods fell in July, but orders for non-defence capital goods rose for the third straight month. Thus, business investment may be bottoming, although it may take some time for this to show up in the GDP numbers. Shipments of capital goods continued to decline.

Even though the US Federal Reserve (Fed) left policy rates on hold in September, it signalled willingness for a rate rise later this year. The Fed’s course depends on the incoming data and we think the numbers are now strong enough for a rate increase in December. The latest comments by Fed officials also point in this direction.


In September, the eurozone’s Economic Sentiment Index (ESI) unexpectedly jumped to its highest level since this January, alleviating the growth concerns that had followed a disappointing composite PMI. The improvement was clearest in manufacturing. The strongest gains were in Germany and the Netherlands, while France, Italy, Spain and Belgium lagged. At face value, the ESI points to faster GDP growth in the coming months of 2% YoY.

This looks too optimistic to us. The decline in the unemployment rate has stalled for five months. Headline inflation rose in September, but this was mainly due to higher energy prices. Core inflation is holding steady at 0.8%. Growth of bank credit to the private sector was mediocre in August. For us, the implication of all this is that the ECB will likely amend its asset purchase programme in December, probably by modifying its self-imposed rules for the programme and extending it beyond March 2017.


Manufacturing PMIs improved in September. The index slipped in the US, but rose in the eurozone. Germany was a positive stand-out. In Australia, the index largely recovered from July’s plunge. In Brazil, the improvement has now stalled for three straight months, but in Japan, the index rose to above 50 for the first time in six months. Eastern Europe PMIs showed broad improvement. In Asia, Taiwan and Vietnam stood out positively.

But in China, the index gained only a notch to a modest 50.1 and in South Korea, it continued its steep downtrend. In India, the index fell to a level suggesting production growth below what one would expect given India’s potential. Despite the data pointing to an improvement from the dip in the first half of the year, we think it suggests the global economy is not yet escaping its modest growth trajectory.


While GDP growth may be marginally improving, we do not think that this is an outright positive for risky assets. Modest growth and low inflation remain challenging for corporate profits. Even in the US, where growth and inflation have improved by more than in the eurozone, corporate profit margins remain under pressure. Low productivity growth is not enough to offset rising unit labour costs. The risk is that companies will continue to economise on their capital expenditure.

While we are sceptical about the recent OPEC agreement, we accept that it could limit the downside risks to oil prices. The tailwind from cheaper oil for consumer spending is fading, however, which is likely to test the consumers’ resilience, especially in the eurozone, where unemployment is still high.

Apart from modest growth, there are clearly risks in the financials sector in the eurozone as well as broader political risks. Even though US equities have outperformed those in Europe so far this year, we prefer to be underweight Europe in our equity underweight.


The theme of steeper bond yield curves proved to be short-lived. In government bonds, we prefer the US over the eurozone due to higher yields in the US and the political risks in the eurozone.

We remain underweight emerging market debt in hard currency versus US Treasuries and global equities as we see relatively high valuations, sluggish economic growth, lacklustre profit growth and low inflation as negative factors for equities. We have hedged the upside potential in risky assets through an overweight in US small caps versus large caps and through cheaply valued out-of-the-money call options on the US S&P500.

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