16 JUL


Asset Allocation

Central banks pivot – and pilot?

The June 2019 G20 summit was the opportunity for world leaders to reiterate their commitment to a soft landing of key economies while taking into account the trade-war impact and increasing geopolitical risks. The long-awaited meeting between China and the US resulted in a mutual agreement to keep communication lines open. It was enough for global equity markets to rise and resume their year-to-date rally. Now all eyes are on the Federal Reserve. Jerome Powell did a pivot on his normalization policy. How far will he pilot? And what’s in store for investors in the upcoming earnings season?


Equities vs bonds

When faced with the choice between equities and bonds, we still prefer equities, if only a tad. We see the potential in several factors: 

1) The world economy is slowing but still growing. 

2) China and the US agreed to resume trade talks at the last G20, which was welcomed by financial markets.

3) Valuation and carry. 

Equity valuation is not excessive. US valuations are above long-term averages, Emerging markets and EMU are getting close, while UK and Japanese are below their historical average. Carry, in the fixed income universe, is the guiding light.  

The road ahead is tricky, though. 

The stock market could gain momentum from the turnaround in manufacturing leading indicators, which is usually a good telltale sign. But they are temporarily out of synch in both the US and the euro zone. Financial markets seem to be ahead of the data. The US and the euro zone markets rebounded in January of this year whereas the manufacturing PMIs were still weakening. It is not the case in Emerging markets. The stock markets failed to rebound in the first half of the year, yet the manufacturing PMIs seem to be stabilizing. Have we really seen the bottom already?

Another good omen is the quality and transparency  of US Federal Reserve communications. Jerome Powell is now known for the pivot but will he be able to pilot the communication, too? Markets (and the White House) expect a rate cut of 25bps at the next FOMC but the communication around it will be tricky. It needs to convey independence from the White House, trust in its ability to prolong the cycle and insight into the current economic conditions, without worrying investors. 

Last, but not least, earnings growth is also a key ingredient for the stock market to perform and the Q2 2019 season is about to start. What matters is to have a match between earnings expectations and published results. A disconnect between the two would disappoint investors more than weak earnings growth. As expectations are lower, published results can be lower without disappointing the market.

Equities: which region?

Taking into account the current economic situation, the level of manufacturing activity, the synchronization with an equity market rebound – or lack of – and the upcoming Fed communication, we believe in staying overall tactically neutral and will proceed to small adjustments within our strategy.  

The US: Powell’s pivot – and pilot? 

We still favour the US region.

US equities are being shielded by US president Trump, who is already aiming at another 4-year term as President in the White House. They are also being shielded by the chairman of the Federal Reserve, Jerome Powell. In his testimony before the House Financial Services Committee, he hinted at an upcoming rate cut, citing the broader global slowdown and other risks facing the US economy: muted inflation, ongoing trade tensions and a looming debt ceiling crisis that has yet to be resolved by Congress. All in all, financial conditions remain accommodative and the risk of monetary error has been removed for the time being.

Valuation is not excessive although it is now slightly above the average historical level. The US stock market has been resilient so far, as can be seen in the 12-month forward earnings announced by listed companies.

Emerging markets: tentative signs of stabilization

Not out of the woods yet

Usually considered a leading indicator of the global cycle, Korean business confidence is improving. The Chinese authorities have been eager to counteract the trade war and stimulate their economy. 

Judging by the Chinese credit impulse, which shows the change in new credit as a percentage of the GDP, we are witnessing the early signals of turning points in the cycle. 

Unlike the US and the euro zone, the evolution of the Chinese equity market is more synchronized with the manufacturing PMIs. We see the impact of the trade war that dates back to April 2018 and the latest turning point, yet the regional index has, however, so far failed to rebound. The region remains on our watch list but, for now, we are staying neutral. 

Euro zone: nominations and elections

Stabilization, but in leadership transition, nonetheless

Major political hurdles are out of the way: the 28 member governments finally reached an agreement early July. 

Ursula von der Leyen will most probably replace Jean-Claude Juncker as head of the EU Commission. The Members of the European Parliament will soon proceed to the confirmation vote. In addition, ECOFIN just adopted a formal recommendation to nominate Christine Lagarde as a candidate for the European Central Bank presidency. Unless the council refuses, she will replace Mario Draghi on 1 November 2019. 

Brexit is a tougher nut to crack. Boris Johnson and Jeremy Hunt are rivals for the Tory party leadership as well as for the coveted prime minister’s chair. Once in 10 Downing Street, a new Brexit deal – or no deal at all – will have to be negotiated with the European Commission and accepted by UK MPs. Until then, political uncertainty dominates in the region, where we remain underweight. Our views on the British pound have also become negative.

From a macroeconomic perspective, leading indicators appear to have bottomed but German economic data remain weak and, above all, the stock market has already experienced a rebound earlier this year, leading us to believe that the market might lack momentum looking forward. It could be found in an ambitious fiscal stimulus but the region is in leadership transition. 

Fund investors are increasingly leaving Europe on the sideline as they do not see how the region will move form a Central Bank stimulus to a fiscal one. 

The consensus underweight is bringing opportunities. European value vs growth is trading at a record discount but sometimes for a good reason:

While we are keeping a neutral stance on the euro zsone and an underweight Europe ex-EMU, we have taken some profit, re-investing in US equities. 

Bonds and currency

In terms of bonds and currency, providing that the global economy avoids a recession, the macro-financial backdrop favours carry. 

The highest carry can be found in Emerging debt in hard currency. 

Our tactical recommendation on high-yield bonds is becoming more cautious. We are downgrading the asset class from positive to neutral. 

We will remain invested in investment grade bonds and Emerging market debt (hard currency). 

In the currency universe, we are staying long Yen, short USD and opting for a short GBP going forward. 

We are also keeping gold as a hedge.