Coffee Break 5/13/2019

LAST WEEK IN A NUTSHELL

  • A sudden and dramatic “Tweet” escalation in the trade conflict impacted various global asset prices in a risk-off environment with a spike in volatility.
  • After Friday’s trade talks in Washington ended without much progress, most recent comments didn’t hinted towards an imminent de-escalation.
  • The Italian press reported that PM Giuseppe Conte is suspecting that deputy premier Matteo Salvini may be preparing to bring down the populist coalition and trigger new elections soon.
  • Data wise: US core CPI was below expectations, but the component breakdown and the PPI supported Jerome Powell’s view that inflation weakness is transient.

 

WHAT’S NEXT?

  • The next step is to see what type of retaliation China would implement. China announced a list of goods on $60bn of US exports to China last year but the tariff was not fully implemented.
  • The following key question is whether the US will move to impose tariffs on the remaining $300bn of Chinese exports. The USTR is likely to release details of its plan soon, which is likely to include mostly consumer goods.
  • Regarding trade, the UK government will explore with the EU how to rewrite the political agreement on future customs ties.
  • On the data front: China’s industrial production, retail sales and fixed asset investment, US retail sales and Q1 GDP reports for Germany and the euro zone will be released.

INVESTMENT CONVICTIONS

  • Core scenario
    • We have a moderately constructive long-term view but are aware of political pitfalls. The Global economy is growing and seems to have hit its trough last winter. 
    • The political risk premium has decreased and central banks have become more dovish, stalling the normalisation of their monetary policy.
    • We take some comfort in the improving macro data in China, bottoming out in Europe and stabilising in the US.
    • In Emerging economies, the measures taken by the Chinese authorities to support the economy are starting to bear fruit and the GDP data just surprised on the upside.
    • In Europe, the latest economic indicators surprised on the upside. On average over 2019, GDP growth is expected to be at 1.3%.
  • Market views
    • Equity fund flows remain negative in recent weeks despite positive performance of markets: investors are staying cautious while the Q1 2019 earnings season was supportive.
    • The corporate sector remains a large buying source via buybacks, and the “black-out“ period during the Q1 earnings reporting stretch should come to an end soon.
    • European and Japanese equity valuations are below their historical average, whereas US and Emerging markets are back to long-term averages.
    • Improving macro data in China and Europe would likely alleviate upward pressure on the USD, downward pressure on inflation expectations and lift global bond yields.
  • Risks
    • Geopolitical issues are still part of unresolved current affairs. Their outcome could still tip the scales from an expected soft landing towards a hard landing.
    • The US – China trade conflict is at the top of the list. It could further weigh on output growth and trigger further spikes in volatility.
    • Persisting slowdown in Europe and Emerging markets in spite of easing measures.

 

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

We stay neutral equities as a whole. We have tactical tilts on regions though as we see more potential for a catch up in specific regions’ macroeconomic data and equity valuation. In our selection, we take into account the re-ignited trade tensions, dovish central banks, low rates and low inflation but acknowledge the rally in risky assets since the start of the year. We favour Emerging markets equities over US equities and we favour euro zone equities over Europe ex-EMU. We stay neutral Japanese equities. In the bond part, we keep a short duration and diversify out of low-yielding government bonds.

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

  • We are neutral equities
    • We are underweight US equities. We expect slower, but positive, earnings growth in 2019. Equity valuations have recovered and are now at fair value as stock prices rose and earnings expectations were revised downwards.
    • We are overweight Emerging markets equities. Chinese growth is the key driver: monetary support and fiscal easing should ensure a growth target above 6%. Trade conflict is clearly not resolved yet. The Fed’s pause is a tailwind for the region.
    • We are overweight euro zone equities. Macroeconomic figures are bottoming out and domestic demand remains decent. Most foreign investors have left the region, leading to a consensus underweight. Valuation remains cheap and below historical average despite the recent rebound.
    • We are underweight Europe ex-EMU equities. The region has a lower expected earnings growth and thus lower expected returns than the continent, justifying our negative stance.
    • We are neutral Japanese equities. Absence of conviction, as there is no catalyst. The region could catch up if the news flow around international relations improves and global growth renews with more traction.
  • We are underweight bonds and keep a short duration
    • We expect rates and bond yields, especially German 10Y yields, to rise gradually from depressed levels.
    • A slower but still expanding European economy could lead EMU yields higher over the medium term. There is an unfavourable carry on core and peripheral European bonds. The ECB is accommodative and will add a new TLTRO.
    • Emerging market debt has an attractive carry and the pause in the Fed tightening represent a tailwind. Trade uncertainty and idiosyncratic risks in Turkey and Argentina represent headwinds.
    • We diversify out of low-yielding government bonds, and our preference goes to US High yield, as a dovish Fed, low inflation and receding recession fears point towards the carry trade.