Coffee Break 7/18/2016

Highlights

United States: The scenario of accelerating GDP seems to be on track.
UK: A surprising short race to Downing Street.
Europe: Search for yield in Europe and on a global scale.
Asset allocation: Cautious on European equities, neutral on US and EM equities and overweight on bonds.

Asset Allocation :

In the US, the scenario of an accelerating GDP growth seems to be on track. Export and new orders are on an increasing trend due to the weaker USD earlier this year. Going forward, this will positively impact growth and earnings. Thanks to a rebound in consumption, H2 GDP growth could be above 2%. Those estimates could prove too optimistic if the upcoming presidential election campaign ends up adding too much uncertainty for US households.

In the UK, the race to Downing Street has been shortened as Andrea Leadsom withdrew from the race. Theresa May is the UK's new prime minister since last Wednesday. She has immediately stated that the "Brexit" will be a success for the United Kingdom. Her main priorities remain:

Putting together a new cabinet, a complex and balancing act given that the Conservative party was bitterly split over the "Brexit" issue;
Negotiating the UK's way out of the EU at her pace and making it the "success" she has vowed to;
Re-uniting a country which ended up deeply divided and in a major political crisis.

The Bank of England Monetary Policy Committee has met on 14 July and has decided to leave the interest rates on hold at 0.5%. The Bank nevertheless stated that a rate cut was certain if the economic situation should fail to improve over the next month.

In Europe, Italian banks continued to add concern not only to the region, but also globally. The Italian banking sector has ended up in a critical combination of slow to non-existent growth, low interest rates, too much non-performing loans following the 2008 and 2011/12 crises in the midst of the "Brexit"'s volatility. Italian leaders and the EU have to find a way out of this crisis by 29 July when stress test results are to be published on a European scale.

Globally, the intensified search for yield has resulted in a strong rotation from equities to bonds across the board into Emerging Markets debt, government bonds, Treasuries, High Yield, TIPS and Municipal bonds.

Our current investment strategy:

Legend
grey : no change
blue : new change

EQUITIES VERSUS BONDS

The investment horizon has been shortened, as visibility has been reduced by the outcome of the EU referendum in the UK. A nimble approach in our investment scenario will be warranted in the coming months as "Brexit" raises more questions than gives answers. We are reassured by the hands-on approach by central banks.

Outside Europe,

The macroeconomic news flow is in line with sluggish but positive growth.
Stabilising macro indicators and the recovery in commodity prices have led to easing financial conditions compared to the start of the year.
The BOJ has its policy rate anchored in negative territory while pursuing quantitative easing and potentially stepping them up, in particular following the recent JPY appreciation.
The PBoC is set to continue its easing policy at a later stage.
Emerging markets remain historically cheap and have been resilient in the Brexit aftermath. A combination of improving fundamentals, stabilising commodity prices and a still dovish Fed have further improved the region's attractiveness.
Emerging markets are seeing inflows from short-term and long-term investors who have realised that the "Brexit" has less impact on distant regions. In light of the latest economic news, we have once again increased our emerging markets exposure.

REGIONAL EQUITY STRATEGY

We have an underweight on equities mainly on European and UK ones. We were underweight before the referendum and will stay underweight UK for now.

We have a neutral stance on US equities, as the US market is less impacted and thus more resilient in the current market environment.
We have a neutral stance on emerging markets equities: the short-term evolution will depend on the evolution of the USD, a more dovish Fed and the global context. We believe there is no reason to reduce exposure to the region.
We are neutral on Japan.

BOND STRATEGY

We have increased our exposure to emerging markets debt by adding to local and hard currency debt.

In the light of "Brexit" uncertainties, we had recently increased our duration, as investors are looking for safe havens and policymakers keep an accommodative stance.
We continue to diversify out of low/negative yielding government bonds:
- We are positive on credit. In the current context, we see more potential in credit than in equities.
- We are positive on inflation-linked bonds. We view the subdued inflation expectations as a temporary phenomenon and expect wages and consumer price inflation data to rise gradually. This implies a re-rating of inflation-protected bonds over the course of the coming quarters.
- Our constructive view on commodity prices is reflected in our exposure on emerging market debt, both in local and in hard currency terms.

Macro :

In China, headline second-quarter GDP expanded by 6.7% YoY, better than the anticipated 6.6%. The statistics bureau warned that the economy faces downward pressure, though the performance in the first half of the year lays a good foundation for achieving the government's 2016 growth target.
In the euro zone, inflation returned to positive territory in June, after four consecutive months of declines (+0.1% YoY).
In the US, consumer prices increased for the fourth consecutive month in June (+1% YoY), as Americans saw a price increase for housing, gasoline and healthcare.
Industrial output surges in June in the US as production increased by 0.6% last month, the strongest gain since July 2015, boosted by automotive products that jumped by almost 6%.

Last week, most commodities posted a positive return, especially copper and cotton.

Crude oil prices rose toward $48 a barrel last week according to data from the top energy consumers. The US and China boosted the oil demand outlook. Gains were nevertheless capped by on-going concerns that a persistent glut of crude oil and refined products could impede a price recovery.
Gold headed for its first weekly drop since May as investors turned to risky assets such as stocks, cutting demand for bullion as a safe haven. Gold dropped 2.4% last week but is still up 26% year-to-date. Silver increased by 0.8%
London copper (+6.5%) edged up on Friday and was set for its biggest weekly gain in four months amid a steady economic growth in China and the prospect of delays to any interest rate hike in the US.
Cotton strongly rose (+12%) as cotton output is likely to decline to hit its lowest level in five years for the current crop year, due mainly to crop damage in major producing states in India.

Equities :

EUROPE

Positive performance for European equities with the Stoxx 600 closing at 338 down up by 3.23% for the week.

European equities rallied as the markets grappled with the lasting effects of the "Brexit" vote.
The Stoxx 600 boost was somewhat diminished on Friday following the apparent terrorist attack in Nice. Travel-related stocks were among the biggest losers on Friday, but for the week, European equities were within striking distance of where they stood before the EU referendum vote in the UK.
The appointment of Theresa May as the UK newest prime minister was favourably received by markets as investors praise that she would instil some clarity in the political future of the UK vs the European Union.
At a sector level, all industries were in positive territory. Basic Resources, Banks and Auto & Parts outperformed the benchmark (7.03%, 6.75% and 6.28% respectively) while Personal & Household Goods (1.59%), Healthcare (0.54%) and Food & Beverage (0.49%) were clearly underperforming.

US

Positive performance for US equities with the S&P 500 closing at 2161 last Friday.

Large caps stocks established a series of new highs during the week, as investors reacted to encouraging developments overseas and a positive start to the earnings season.
Smaller-cap benchmarks and the technology-heavy Nasdaq Composite remained nonetheless below the records established in 2015.
Even though aluminium giant Alcoa reported a smaller-than-expected decline in quarterly profits, several positive earnings reports came during the week. Nonetheless the banking giant JP Morgan beating expectations, thanks to cost reductions.
At a sector level, Materials, Financials and Industrials outperformed the S&P 500 (3.91%, 2.57% and 2.55% respectively), while Consumer Discretionary (0.49%), Consumer Staples (0.08%) and Utilities(-1.05%) were underperforming.

EMERGING MARKETS

Emerging market stocks were set to end Friday with the biggest weekly gains since March.

With German issuing its first negative-yield 10Y bond and more stimulus expected in Japan, investors piled into emerging assets almost across the board.
Policy easing is underway with Malaysia surprising on Tuesday with its first rate cut in seven years and Singapore's below-forecast second quarter growth pressuring the central bank to act.
Messaging app Line, an affiliate company of Naver Corp. in Korea, made its debut at the Tokyo Stock Exchange and closed its first trading day up by 32%.
At a sector level, Materials, Financials and Energy outperformed the index (3.58%, 3.49% and 3.17% respectively), while IT (1.28%), Consumer Staples (1.06%) and Healthcare (0.34%) were underperforming.

Fixed Income :

RATES

Risk sentiment continues to be supported by expectations of accommodative central bank policies while fears on a full-blown European crisis decreased.

This brought global core sovereign rates higher, while non-core sovereign rates outperformed.
Next to improving risk sentiment, US sovereign rates were also driven upwards by better US labour and inflation data.
The BoE voted to leave bank rate unchanged at its July policy meeting, but preannounced action in August with probably a rate cut and a boost to its funding for Lending Scheme.
With economic data coming in somewhat softer in the euro zone and scarcity issues on sovereign debt becoming more important, investors will monitor if any adjustment in QE rules will be announced at next week ECB meeting.
Core sovereign rates increased, with the US lagging euro zone and US peers. 10Y US, UK and German yields increased to respectively 1.59%, 0.84% and 0%. Italian and Spanish 10Y spreads tightened somewhat, reaching 1.25% and 1.23% respectively.

CREDIT

Risk-on mood dominated the credit market, helped by the rapid designation of the new UK prime minister and an expected accommodative Bank Of England.

Although investment grade credit has returned to pre "Brexit" level, subordinated financials still traded 7-10bp wider.
The primary market has not yet bounced back and the earnings season has started.
The European banking system is particularly scrutinised regarding UK banks exposure to commercial real estate after 6 property funds were frozen and Italy is facing €350bn non-performing loans with the European oldest bank, Monte Dei Paschi, on the verge of collapsing.
Only €3.3bn were issued last week, a third of the weekly average volume of 2015.
"Brexit" uncertainties have moderated US issuer appetite to tap the euro market. Even if the supply was thin, investors demand is still strong.
JP Morgan released good results with revenues in line with consensus but net income in the higher range of views. Revenues from capital markets performed well thanks to better operating environment.

FOREX

Risk aversion settled down last week, as US macroeconomic data remained resilient and political uncertainties in the UK diminished, with the confirmation of Theresa May as the new prime minister.

GBP reversed course and displayed a 2% positive return against the EUR.
High-carry currencies performed very well (ZAR, BRL, CAD, AUD.), to the expense of traditional safe-haven ones (JPY or CHF).
The USD kept trading in a tight range against the EUR, as uncertainties surrounding the outlook for US monetary policy remain elevated.