As expected, the US Federal Reserve (Fed) made no changes at the FOMC meeting last week. Fed Chair Janet Yellen said that reducing the Fed’s balance sheet would begin ‘relatively soon’. In our view, the Fed will announce the start of the balance sheet reduction in September and start it in October. Yields moved slightly to the dovish side, helped by a comment from Donald Trump saying he liked low rates and did not exclude Yellen being considered for re-appointment in her current role in February 2018.
Commodities rallied strongly as the price of Brent crude rose by some 8% following a marked reduction in US crude oil inventories. In addition, Saudi Arabia announced it expects to implement deep cuts in oil exports.
In our asset allocation, we implemented a long position on the US dollar versus the euro as we expect the dollar to rebound progressively. We also closed our underweight in emerging market dollar debt.
US dollar: could it fall further?
Last week, the International Monetary Fund (IMF) released its updated global economic forecasts, contending that ‘the recovery in global growth is on a firmer footing’. Although its forecast for headline global GDP growth in 2017 and 2018 was unchanged, it revised down its growth forecasts for the US and the UK while increasing them for Europe, China and Japan. In 2016, the consensus expectation was of desynchronised global growth, with the US moving ahead and Europe and the rest of the world lagging behind. This view culminated after Donald Trump’s unexpected election win. His pledges on trade, tax reform and fiscal stimulus gave rise to a new market trend – the “reflation trade” underpinned by the prospect of a better environment for risk assets and yields that would rise as inflation picked up.
These expectations remain unrealised. With President Trump so far unsuccessful with any sweeping reforms, the view discounted by the market has reversed and wiped out the “Trump trade”. A few months after the US election, the US dollar index, DXY, started to weaken and is now at a 30-month low. Despite US job market tightness and encouraging growth figures, the Fed has been unable to normalise monetary policy as quickly as anticipated, notably due to softer inflation prints. Some 80% of the trade-weighted DXY index comprises European currencies, with the euro accounting for 60%. For that reason, the euro has strengthened significantly against the dollar so far this year. Even though financial markets have completely retraced the reflation trade, we still think President Trump will achieve some reforms that would support the US economy. The Republican Party is likely to become more effective at voting in and implementing at least some level of tax reforms as its need for a political win before the mid-term elections next year is becoming ever more urgent. We believe the euro’s valuation against the US dollar is stretched and will progressively reverse as the US dollar rebounds.
In the eurozone, the economy is generally progressing well. Although PMI data seems to have passed its peak, the latest print remains well into expansionary mode.
Q2 earnings: US ahead on surprises but Europe leads on EPS growth
While the second quarter earnings season is not yet over, 78% of US companies have beaten earnings per share (EPS) estimates, compared to only 56% in Europe, down from 66% in Q1. However, this does not mean that US companies are recording higher earnings growth. Thus far, average Q2 EPS growth in Europe is 16%, well ahead of the US average of 7%. The higher proportion of upside earnings surprises in the US is mainly due to pre-season downward earning revisions, whereas in Europe, consensus expectations were higher. That said, looking at ex-energy figures, European and US year-on-year earnings growth is quite similar, with Europe at 7% and the US at 6%.
Asset allocation: overweight US dollar; taking profit on EM dollar debt
We have added a long US dollar position versus the euro. In line with our FX approach, this is a long-term, high-conviction trade. The rebound in the US dollar could happen sooner rather than later as market participants are discounting weak data in the US while expressing positive views on the eurozone. A relatively minor change in outlook could thus induce a reassessment of expectations and a repricing. As the eurozone PMI seems to have reached a peak, it could signal an upcoming change in market sentiment.
We have closed our underweight in EM dollar debt as valuations have cooled down from expensive levels. Spreads are quite wide both on a historical basis and relative to European and US corporate spreads. One driver underlying the recovery in EM dollar debt has been the improvement in commodities markets. We are now neutral on commodities. In EM local currency debt, we remain constructive as emerging currencies continue to appreciate versus the US dollar.
In fixed income, we continue to be broadly neutral duration on a tactical view. Longer term, we expect to move back to an underweight duration position, particularly in European bonds, as we expect the ECB to be one of the first major central banks to adopt a less symmetrical reaction function and place greater emphasis on prudent management of financial markets.
As for our other strategies, we regard US equities as more overvalued than European ones. We are overweight eurozone equities versus US and UK equities. This also reflects the fact that our forecasts for UK corporate earnings are much lower than consensus expectations and, as such, we expect UK equities to underperform those in most other major equity markets.
On real estate, European stocks have rallied significantly this year, while US real estate has lagged. This encourages us to maintain our overweight in US real estate as we expect this divergence to reverse over the coming months amid a pick-up in demand for US real estate.
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