House View: Q2 2017

Climbing a wall of worry but normalisation ahead

  • Investors are climbing a wall of worry, slowly moving away from the deflation mind-set
  • Crucial turning point in monetary policy ahead
  • Equities are set to outperform, while duration faces challenges

Investors are climbing a wall of worry. A pretty high wall, but we think we are close to seeing the top of it. Fundamentals are improving, investors’ mind-sets are slowly moving away from short-termism and political noise, and the focus is back on globally-improving economic newsflow. While we still consider it a downside risk to the outlook, we do not expect the global economy to head down the path of long-term secular stagnation. Beginning in the second half of last year, we think the market has finally started to price in a more positive global outlook, with fixed income markets in particular starting to move away from the mind-set of deflation that has dominated in recent years.

Indeed, there was an important inflection point around July last year (Figure 1). A synchronised global improvement in economic activity led to major moves in and across asset markets. As a result the major central banks have been obliged to acknowledge the improvement in growth and inflation prospects and start to consider exit strategies for some, or less gradual removal of accommodation for others. In the light of recent upbeat data, instead of adding to fear in global markets (“we still see downside risks”), monetary policy is now injecting confidence (“we see improvements in fundamentals”). As detailed in our economic outlook, we think the Federal Reserve will raise rates two more times this year, and that the ECB will start discussing exit options. Obviously this raises several questions for global markets. After all, many in the market have never seen a full tightening cycle in the United States. The Fed funds policy rate was anchored at 0 per cent to 0.25 per cent for seven years. The ECB rate is still negative and asset purchases are expected to continue at least until the end of the year. The Bank of Japan is also still pursuing a negative rate policy and is experimenting with “yield curve control”. The turning point for global monetary policy is now in sight and is likely to impact global markets significantly, as fundamentals re-assert their influence.

Stronger global growth should translate into higher corporate earnings growth, while rising inflation supports term premia and represents a headwind for fixed income markets in the US and Europe. Keeping monetary policy so loose globally for years was justified, but it was inevitable that it would affect investor behaviour. This can be seen clearly in the asset allocation choices by investors in recent years, with very significant allocations into developed market fixed income at the expense of global equities and emerging market assets. While this has adjusted somewhat in recent months, there is still a long way to go. If there is a skew to our central view, it relates to upside risks for both growth and inflation. As a result we prefer owning equities to duration, with important differentiation to be made within each asset class across different geographies.

The cross-correlation both between and within asset classes was distorted for much of the post-crisis period by central bank policies. However, as those policies have come to an end, correlations have begun to decline. Investors have to factor in higher dispersion within the equity space, but also within other asset classes. Figure 2 shows the correlation between equities and bond prices. The change in correlation regime coupled with a low volatility environment is a first step towards market normalisation. Indeed, the whole risk-on/risk-off approach with consistently high cross-asset correlations is not the historical norm. One might argue that asset prices have only just started to adjust to the idea that real rates might not stay so low forever. US markets are leading the way. For example, US 10-year breakevens at around 2 per cent are already close to historical norms.

The view held by some commentators that Fed balance sheet expansion was the single driver of US equity markets seems not to hold anymore, as underlying earnings growth seems to have underpinned recent stock market advances (Figure 3). There was a case for saying that Quantitative Easing policies support multiple expansion as, for example, the low-yield environment persuaded companies to issue cheap debt and buy back stock. But looking forward we think equity prices will reflect an improved earnings outlook, based on stronger growth (Figure 4). And the potential for more active fiscal policy (especially tax cuts) should also support earnings and make the valuation adjustment quicker.

We prefer a smaller allocation to US equities as we find the valuations provide a less attractive risk reward profile. Long-dated US Treasuries are now a more attractive proposition to reduce risk at portfolio level and provide balance. While we think there is still a case for higher yields in the US, the extent of the move higher in long-dated yields should provide protection if we were to be wrong in our central scenario. For example, if we were wrong on the reflation theme, or on our slightly more aggressive Federal Reserve path than what the market is currently pricing in, then longer-dated Treasuries are likely to rally. Similarly, if we were wrong about the political outlook in Europe.

We take a somewhat different view in the Eurozone. We find equities still attractive in valuation terms (the weight of financial stocks certainly helps), while sovereign bonds and also credit markets are in our view offering poorer risk-reward profiles going forward. Indeed, given the ECB has probably reached maximum easing and is likely to be looking towards exit strategies later this year, as the underlying economy seems to be improving, we strongly prefer owning equities versus sovereign fixed income and credit in Europe. Indeed, depressed sentiment, international positioning, valuation, and potential for earnings re-rating mean we continue to strongly overweight European equities. We think European equities offer the best expected return on a one-year horizon, with risks on the volatility outlook. Our central view is that populist parties may increase their share of the vote, but will not win any major election in the Eurozone. Italy and France are the greatest risk to that outlook.

Emerging market debt and equities should both do well in our central view of the world. Our view on emerging markets assets began turning more positive at the end of 2015, and we continue to like both equities and, more selectively, bonds in the emerging market space. In particular, the idea that the Chinese economy does more of what we have seen in the last few quarters, i.e. prioritises and achieves stable growth, is a support for global emerging markets. At the same time, the fact that the Federal Reserve risks being somewhat behind the curve also means that we expect curve steepening without much dollar appreciation which is also positive for the asset class. We strongly prefer, on valuation grounds, having exposure to local debt (overweight) versus hard currency debt (strong underweight), and like EM equities (strong overweight) in general and Chinese equities in particular. Hard currency debt has become particularly expensive in our view.

The United Kingdom outlook is obviously clouded by Brexit. If negotiations do not progress well, uncertainty could easily ramp higher again. We believe that much of the recent UK equity move is attributable to sterling depreciation. We see downside risks for both equity and bonds going forward and have an underweight stance and a neutral view on the currency.

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