Author: NN Investment Partners
The fundamental and behavioural picture continues to support risky assets, even as policy and political risks rear their heads in many parts of the world.
The environment for risky assets is supportive. The macro data are strong and surprise positively whereas due to the absence of inflation, central bankers have the luxury to adopt a very gradual tightening path. This will continue to spur the search for yield despite historically tight valuations in the fixed income spread categories. The corporate side is also in good shape with double-digit earnings growth and healthy balance sheets. This combination bodes well for shareholder-friendly strategies through higher dividends, buybacks or M&A activity. In addition, the equity risk premium is still attractive especially in the Eurozone and Japan.
Maintain cyclical bias in asset allocation
The fundamental backdrop for equity markets remains strong. Since the summer, macroeconomic data have tended to surprise on the upside. Macro surprises in developed markets have been catching up with emerging market data, which are still good despite a levelling off in China. At the same time, inflation overall remains subdued and below targets of the Fed, the ECB and the BoJ. Nevertheless, we have seen some early signs of potential reflation, including strong input price components in US September ISM for manufacturing as well as services. Expectations of monetary policy normalization have been brought forward somewhat, particularly for the Fed. Overall, though, the normalization path is still expected to be gradual, both for the Fed and for the ECB. The bulk of the ECB’s purchase program tapering is expected to be announced at the next policy meeting, scheduled for 26 October. The Fed has meanwhile started its gradual balance sheet unwinding process.
For the US Q3 earnings season, the hurdle rate has been lowered over the past weeks from 5.2% to 3.6%. This does not look challenging, given the strength of the economy in the quarter and the positive impact of a weaker USD on US earnings. Insurance results are likely to be weaker due to costs related to natural disasters. Overall, though, good corporate results could give additional support to the market. The outlook for 2018 is also strong, especially for the US, where earnings are expected to rise another 11%, and for emerging markets, where growth is seen at 12%. The outlook is more moderate for the Eurozone, but even here the consensus expects earnings growth of 8.5%, near the long-term average.
We maintain our cyclical bias in the sector allocation. This strategy is supported by three elements: better-than-expected macro data, higher bond yields following gradually tighter monetary policy, and stable to rising commodity prices. This environment would also be supportive for the financial sector, our preferred sector, given its low valuation and positive correlation with bond yields. We also have a medium overweight in technology which should fare well in a low nominal growth environment. Energy is a small overweight. We remain underweight defensives and yield plays.
No shortage of political uncertainty
Equity markets have recently continued pushing higher while implied volatility has remained close to historic lows, despite fluid political situations in many parts of the world, including Europe. Eurozone equities have lagged the broader market as the independence movement in Catalonia put pressure on Spanish bonds and equities.
Markets see the Catalonia question, for now at least, as a local issue with negligible chance of contagion. Secession looks difficult in the short term because of a number of practical problems. But at this stage it is not clear how the Spanish and Catalonian governments can unlock the situation. Markets initially reacted well to the regional government’s suspension of the independence call, but much will also depend on the national government’s reaction. A consequence at the national level could be a lack of support for approval of the Spanish 2018 budget. Prime Minister Mariano Rajoy’s minority government needs the votes of Parliament’s five Basque members, whose approval looks doubtful following the events in Catalonia.
In Germany, the coalition talks between CDU/CSU, the Greens and the FDP continue. No quick agreement is expected given the large divergences that exist between the FDP and the Greens on several issues. We do not consider lengthy talks harmful for the equity market, given the strength of the German and Eurozone economies, although the outcome will be important in the medium term for the reinforcement of the Eurozone’s institutions.
In Japan, elections will be held on 22 October. We see little risk of a negative surprise. According to the polls, the LDP-Komeito led by Prime Minister Shinzo Abe coalition will win a third-straight majority in the lower house, which would ensure the continuation of Abenomics and the re-appointment of Haruhiko Kuroda as BoJ governor. Meanwhile, economic data for Japan are strengthening. Key for the performance of Japanese equities is the yen, given the importance of the export-dependent industries. In this respect, the global growth recovery is also positive for the Japanese market.
Upgrade USD IG, downgrade EMD LC rates
In the US, the focus has turned towards the tax plan, which takes the form of a corporate tax cut. The cut is good news for equity markets and especially for small caps, which have on average a higher tax rate. Given Trump’s sometimes difficult relation with Congress, it may take some time before a plan gets approval, but we see the probability of a tax cut being passed as higher than 50%. The combination of improving macro and the potential fiscal stimulus a tax cut would bring is shifting Fed expectations somewhat to the hawkish side. On balance, some form of “reflation light” and US policy expectations appear to have brought the Fed’s policy normalization path forward somewhat. In this environment we moved USD IG to overweight. The shift in market attention to US tax reform already appears to have supported momentum and flows to US investment grade (IG) credits. If it includes US foreign corporate cash repatriation and an elimination of interest deductibility, USD credit would come into favour, particularly versus EUR credit. The expected decrease in leverage would favour USD IG relatively more. Less regulation would also be a tailwind to USD IG.
We moved emerging market debt local currency (EMD LC) rates to underweight. Our quant signal set has moved in favour of IG as a block, mainly to the detriment of the EM block. A number of indicators are weakening for EM: economic surprises (versus DM), commodity prices, short-term momentum, and Fed expectations. A more hawkish Fed than currently anticipated would also be a further headwind. More specifically for EMD LC rates, short-term momentum has weakened recently while the short-term EM inflation path and EM inflation surprises have become a headwind. EMD LC also witnessed outflows recently. We have also moved Eurozone Peripheral Treasuries (EPT) to underweight. Political risk in the periphery is likely to increase in the coming months. The Catalonia question may linger for some time and weaken Spain’s central government. Italian elections are likely to lead to a political stalemate. The ECB’s taper decision at the 26 October meeting may also be less supportive to EPT. We expect EPT’s relative momentum within spread products to weaken gradually as a result.