Author: NN Investment Partners
Investors had a hard job digesting a vast flow of attention-grabbing news last week. Jerome Powell’s first policy meeting as Chairman of the Federal Reserve, the announcement of new tariffs by the Trump administration, and reports about the misuse of the data of millions of Facebook users dominated the headlines.
A clear risk-off move in markets was the result. After reducing our risky asset exposure to neutral, we decided last week to neutralize our government bond exposure as well.
Fed expresses confidence in economic outlook
It was supposed to be the week of Jerome Powell. Last Wednesday he presided his first meeting as Chairman of the Federal Reserve. A new face in charge of the most important central bank in the world, facing his first public exchange of words with the press on the state of the US economy and the outlook for monetary policy, usually is one of the most important market events of the year.
As expected, the Fed raised rates by 25bp to a target band of 1.5-1.75%. The press statement suggested the central bank’s assessment of the economic outlook remains upbeat. Growth forecasts were revised upwards, to 2.7% in 2018 and 2.4% in 2029 (from 2.5% and 2.1% respectively), likely incorporating the fiscal boost from the additional spending package agreed by Congress in February. Also the forecast for inflation was revised upwards slightly, to 2.1% in 2020 on both the headline and core inflation measures (from 2.0% previously). This is a small but significant change, because it means the Fed is now projecting inflation a touch above target, strengthening the case for more rate hikes. Furthermore, the projections of future rate hikes illustrated by the ‘dot plot’ suggested that rates will rise somewhat faster and further than previously expected. The median dot for 2018 still pointed at two more rate hikes this year, but for 2019 the projection indicated 3 instead of previously 2 rate hikes. The median expected long-run rate has shifted up from 2.8% to 2.9%.
Last month we changed our Fed call from 3 to 4 hikes in 2018 and from 2 to 3 hikes in 2019, following an improvement in the nominal growth outlook as well as the fact that financial conditions are still easier than a year ago. The risks to this view are seen as balanced, although the recent increase in market turmoil could potentially dent risk sentiment and negatively affect financial conditions.
Trade tensions escalate further
This increase in market turmoil is mainly the result of the rise of global trade policy risks since the start of the month. Tensions further intensified last week, as it appears that the Trump administration’s trade tariff intentions are mainly directed at Asian economies and China in particular. A string of countries were (temporarily) exempted from the US’ steel and aluminium import tariffs, such as Canada, Mexico, Australia, Brazil and the European Union, but China and Japan were not. Furthermore, Trump signed a memorandum that targets to put a tariff on USD 60 billion of imports from China. His administration will announce a list of targeted goods, to be followed by a 30-day consultation period, which will be basically aimed at technology on which the US accuses China of having infringed intellectual property rights. In a reaction, China urged the US to “pull back from the brink” and threatened with retaliation.
Obviously, trade tariffs, potentially culminating into a full-blown trade war, have no real winners and are without exception bad news for risky assets. Global equity markets sold off significantly at the end of last week after Trump announced his Chinese tariff plans.
Threat of regulatory scrutiny weighs on tech sector
Finally, the technology sector was hit last week by the news that the data of 50 million users of the largest social network in the world was possibly misused by an external data analytics firm to manipulate voting behaviour during several elections. In the short run, the fallout of a rising threat of increased regulatory scrutiny could easily weigh for a bit longer on the technology sector, which has so successfully pushed global equity markets higher over the last 12 months. Given the popularity of the sector in investors’ portfolios, the marginal buyer of these tech stocks might be hard to find as long as headlines about data leakage continue to swirl around. We hold on to our neutral stance on technology stocks for now.
Neutral stance on all asset classes
The continuing political turbulence in the US, the risk of escalation on trade tariffs and the recent news flow on Facebook make us more comfortable with a neutral tactical asset allocation stance. The rise in political uncertainty is not the only factor that played a role in our decision to neutralize our stance on risky assets earlier this month. Other drivers were the diminishing support from macroeconomic and earnings data, while fiscal, trade and monetary policy are also becoming less supportive.
Last week we decided to also bring our government bond allocation back to neutral from a small negative, leading to a fully neutral view on all asset classes. This lack of conviction should not be interpreted as a lack of market understanding on our side. Our preference for a neutral allocation is based on the fact that we cannot find any clear signals for future market direction at the moment. And where we see some small supporting factors for an asset class, other small negative factors are counterbalancing this.
Our decision to remove the only active view we had left, underweight government bonds, is easily explained when looking at our signal set. The fundamental support for the underweight has gradually vanished over the past few months. Weaker macro surprises in Europe and the risk of negative spill-overs from US trade tariffs add to the fundamental arguments for a neutral stance. The change in our market dynamics signals is even more significant, as it moved from a clear negative reading in February to almost neutral today. Sentiment and momentum are no longer arguing for an underweight position and fund flows and positioning have even become supportive for the asset class. There are still large short positions in US Treasuries.
Reasons enough to become more constructive on risky assets
It is difficult to predict when we will make the next change to our allocation. We still foresee bond yields to be higher at the end of the year. The global economy is still growing strongly, also after the string of weaker data in Europe, for example. Central banks will continue their gradual normalization policy. We still think that decent earnings will support equity, but earnings momentum is weak at the moment. Strong employment numbers and consumer confidence should provide tailwind for real estate, especially after lagging equity markets so much. So there are plenty of reasons to become more constructive on risky assets relative to government bonds. Yet, for now, we feel comfortable with a neutral stance in view of the increased political uncertainty, trade tensions, and the slowdown in macro and earnings momentum.