The synchronised cyclical uptick on a global scale has been among the drivers of the equity market outperformance vs. bonds during this first quarter. Risky assets have risen along with the marked improvement in the economic news flow. We note, however, that most of the upside surprises in US data has come from “soft” survey data rather than “hard” activity data. Our reading of the current gap between survey optimism and actual activity is as follows: we would not be surprised to see risky markets making a pause allowing activity to catch-up. Clearly, if reality does not catch up with current hope, equities would become vulnerable. Looking forward, it will therefore be key to assess if the current optimism is translating into stronger activity. The cliff-hanger in Washington on the health care bill implies that the upcoming tax overhaul and infrastructure package are no plain sailing.
The latest BofA Merrill Lynch Fund Manager Survey has confirmed an increase in equity overweight as fears that continental Europe would suffer an anti-EU, populist wave have receded somewhat after the Dutch general election. It has to be seen if the next hurdle, the French presidential elections next month, confirms this behaviour, which would clearly be a positive sign for European assets.
In this context, we keep our overweight on equities while taking partially profit on our US equity exposure as we interpret the gap between survey optimism and actual activity as a tactical warning on US equities.
Our current investment strategy on traditional funds:
grey : no change
blue : change
EQUITIES VERSUS BONDS
We are overweight in equities versus bonds:
- The macro news flow is still well-oriented. Data released in the first months of the year continue to surprise on the upside, confirming our view of a synchronised global expansion. In particular, upside surprises on growth and inflation confirm the improvement in nominal growth rates, fuelling corporate earnings growth.
- Central banks’ actions are decoupling but their tone has turned less dovish:
- The ECB has extended its stimulus programme until December 2017, standing ready to increase the programme in terms of size and/or duration “if the outlook becomes less favourable or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation”.
- After the Fed interest rate hike in March, the central bank still expects two additional moves this year. The acceleration in the Fed tightening pace is at odds with accommodative policies in Japan, the euro zone and, to a lesser extent, the United Kingdom.
- Equities have an attractive relative valuation compared to credit, and their expected return should be boosted by the end of the earnings recession in the US and Europe.
- Oil markets continue their rebalancing. However, while OPEC members are bringing back oil production to more durable levels, US rigs have been re-opening, implying a greater production.
- Important political risks remain: “Brexit” negotiations, elections in France and the new US administration imply high dispersion of possible outcomes. The political risk premium weighs on European equities.
REGIONAL EQUITY STRATEGY
- We have maintained our overweight on euro zone equities. A more robust and geographically broadening economic expansion, as witnessed by the most recent PMI indicators, an accommodative central bank and a high valuation discount linked to political uncertainties underpin the attractiveness of the region’s risky assets.
- In the UK, Theresa May will notify the EU on 29 March, under the Article 50 process, that the UK is leaving the European Union. In this context, we keep an underweight position on UK equities. The uncertainties of the “Brexit” conditions and their impact on the economy lead us to avoid domestically-oriented small and mid-caps.
- We took partially profit on our US equity overweight as the gap between “soft” survey data and “hard” activity data has widened to unprecedented levels. US stock markets have benefitted from post-election optimism among consumers and businesses but activity has yet to follow sentiment. We nevertheless maintain a small overweight in the region.
- We have a slight overweight on Japanese equities. Stronger global growth, a supportive domestic policy mix and a relatively weak currency are among the main performance drivers.
- We hold a slight overweight on emerging market equities. They still benefit from attractive valuations in a robust global growth context, but remain vulnerable to potential protectionist measures in the US. Earnings growth has been revised a little upward thanks to increasing commodity prices. Meanwhile, India remains our preferred emerging market. Indian stocks recently hit a record high as the victory by Narendra Modi’s Bharatiya Janata Party in the key state of Uttar Pradesh should bolster his economic reform agenda and strengthen his claim to a second term in national elections in 2019.
- We maintain our underweight on bonds and keep a short duration. With a more hawkish Fed and increasing inflationary pressures, we expect interest rates to maintain their uptrend. The improvement in the European economy could also lead euro zone yields higher, barring political risks.
- We have a neutral view on credit, as spreads have already tightened significantly and a potential increase in bond yields could hurt performance.
- We continue to diversify out of low/negative yielding government bonds:
- We remain positive on inflation-linked bonds as we expect rising wages, increasing price pressures in China and potential stimulus to push inflation higher. Potential US protectionist measures are a wild card.
- We have a relative value strategy: long German Bund / short French OAT due to increasing uncertainties surrounding the French election. We see the strategy as a hedge against the European political risk.
- We have a slight overweight in emerging market debt, both in local and in hard currency terms. Carry remains attractive and negative financial implications of the US presidential election, due to a stronger USD, are receding.
- We are close to a neutral high yield exposure. The spread compression has exceeded our targets on both sides of the Atlantic.