European political risk is rapidly fading, enabling investors to focus on growth

Executive Summary

• European political risk is rapidly fading, enabling investors to focus on growth.
• The Eurozone has taken the lead in the ongoing expansion.

• Central banks are expected to be at the forefront in the coming months with a Fed rate hike in June, balance sheet reduction in H2 and potential ECB tapering after the summer.

• Positioning on the reflation trade has continued its reversal.

Main convictions

• Positive on EMU and emerging equities

The US cyclical expansion stalled in Q1 and activity data has yet to catch up with survey optimism. The narrowing of the gap between economic surveys and the actual economic activity is not yet a result of an economic activity improvement. Consequently, we have kept a more attentive view on US equities. On this side of the Atlantic, the European recovery is well on track, leading to above-potential growth in 2017-18. This has led us to raise our earnings expectations for Eurozone equities, on which we still have a strong conviction.

Meanwhile, protectionism fears have decreased (China, NAFTA), but have not completely disappeared. The deflation dynamics registered until last year is no longer at work, but the global inflation momentum is subdued.

We have maintained a positive strategic view on equities, though remaining more cautious from a short-term perspective. However, we still have strong regional convictions in the EMU and emerging markets, while keeping a short duration.

• Political risk has switched from Europe to the US

The French election result has led to a sharp decline in the European political risk premium. We are now confident that we are past the peak of EMU policy uncertainty, as the Italian risk on the horizon appears manageable. Instead, political uncertainty has increased in the US. The lack of political success in Congress, including the critical reception of the FY 2018 budget request, and escalation of sensitive issues question the credibility of the Trump presidency. Slippage in the timing of the fiscal stimulus appears to be just one source of uncertainty. We are waiting for more clarity:

• • Domestically: on US reflation through fiscal stimulus, tax cuts and regulatory easing
  • Internationally: on geopolitical tensions with Syria, Iran and North Korea.

Brexit negotiations remain, nevertheless, also a source of political uncertainty, especially after the disappointing election result of the Theresa May’s Conservative Party.

• Central bank dovishness to recede

After the rate hike in June, the next step in the Fed’s tightening process will be through balance-sheet reduction, where timing and size are uncertain. In the meantime, the ECB has already changed its guidance, omitting to say whether interest rates might be cut again. Tightening in developed markets is at odds with monetary policy easing in emerging markets, including Brazil. In addition, EM bonds are benefiting from a weaker USD and strong fundamentals.

CROSS-ASSET Strategy

Tactical and regional portfolio positioning

GENERAL OVERVIEW: Equities vs. Bonds

The global context remains supportive for equities versus bonds from a mid-term perspective. The expansion continues and the Eurozone has clearly taken the lead, with robust and improving economic indicators (PMI), while the soft patch in the US should only be temporary. Outside the US, economic publications have continued to surprise on the upside and the backdrop remains favourable, especially in the Eurozone. In the meantime, central bank dovishness is expected to recede. Central bank stimulus remains significant outside the US for the time being.

At the same time, equities are still more attractively valued than credit and their expected return should be boosted by improving earnings. Furthermore, valuation multiples should be able to withstand the expected slight increase in inflation.

Despite the geopolitical risks, such as the Brexit negotiations, the unpredictability of the US president and tensions in Syria, Iran and North Korea, we see few negatives for equities, in which we are maintaining our positive mid-term view. We nevertheless recognise that markets are missing a short-term catalyst to continue their uptrend in the short term.

REGIONAL EQUITY STRATEGY
Overweight EMU and Emergings, Underweight UK

• EMU equities are our strongest conviction. An ongoing, more robust and geographically broadening economic expansion, an accommodative central bank (for now) and strong corporate earnings momentum underpin the attractiveness of the region’s risk assets. The French election results have led to a sharp decline in the political risk premium

• We are positive on emerging markets, which are benefiting from attractive valuations in a robust global growth context. China should not trigger a systemic risk this year and most recent data (foreign reserves, retail sales, industrial production, loans) are rather supportive.

• We have maintained a more cautious, but not negative view on the US. Activity has yet to follow sentiment as US stock markets have benefitted from post-election optimism among consumers and businesses. We identify an execution risk (at least a delay into 2018) in the expected fiscal stimulus

• We are clearly negative on the UK. The uncertainties of Brexit conditions, especially since the outcome of the election, and their impact on the economy leads us to avoid the region. While the bulk of the exchange rate adjustment might be behind us, we expect the earnings growth expectations to soften somewhat once the negotiation talks start in earnest.

• We have a neutral view on Japanese equities. Strengthened global growth and a supportive domestic policy mix are among the main performance drivers, but a weaker currency is warranted to gain more conviction.

FIXED INCOME STRATEGY
Negative on government bonds, short duration

• With a tightening Fed and on-going inflation pressures, we expect rates and bond yields to remain on an uptrend. We expect rising wages and potential stimulus to push inflation higher. Potential US protectionist measures are a wild card
• he improvement in the European economy could also lead EMU yields higher, as political risks recede and the ECB, which has already changed its guidance, should start detailing its tapering during H2
• We are cautious on credit, as spreads have already tightened significantly and a potential increase in bond yields could hurt performance.
• We are keeping a small diversification in high yield. The carry of the asset class remains attractive and default rates are low but we see little room for further spread compression.
• We continue to diversify towards emerging debt. Contagion from Brazil to the rest of emerging markets has been contained. While fiscal consolidation reforms and the growth recovery in Brazil are likely to slow down, we don’t believe that monetary policy easing is completely derailed.
• We still have inflation-linked bonds. Despite the recent setback for reflation trades, it’s not the end of them. After a run of positive surprises and commodity price effects, inflation momentum will continue to stabilize, but at a slower pace. Global inflation will eventually be driven by a rising US CPI due to the prospect of higher wages and US fiscal easing.  

COMMODITIES

• Despite the OPEC agreement, that resulted in a production cut expansion ofnine months, investors remain cautious regarding the US oil production and inventories, which remain high.