All eyes are on central banks

Asset allocation strategy - 2/5/2018

Rarely has a financial environment been so clearly marked out. The synchronised global recovery continues apace without generating any excess or serious imbalances and inflation is still tame.

Risk assets have posted sharp gains

And now the IMF has just revised up its growth forecasts for 2018 and 2019. What’s more, investors are now less concerned about a possible financial crisis in China. Beijing has so far succeeded in its cautious drive to stop debt levels ballooning and restrict shadow banking but without stifling economic activity. With all lights flashing green and liquidity abundant, risk assets once again surged in January. We recognise the fundamental quality of the environment but tactically we have cut exposure to risk assets.

Valuations were already more or less stretched 6 months ago but since then, the S&P500 alone has gained 15% amid very low volatility. In our view, this means the market is ripe for profit taking. And a number of risks are clearly present:

- All eyes are now focused on leading central banks which have moved into a monetary tightening phase. Not only is the Fed pressing on with its rate hikes, but the ECB has more or less confirmed its intention to end its quantitative easing programme - the only question is when exactly - and deliver forward guidance on its first move to raise rates. In Japan too, markets are wondering how long such expansionist monetary policy can be sustained now that the Bank of Japan’s stance has become harder to read. All this has put pressure on bond markets. 10-year government bond yields both in Europe and the US have gained 20-30bp so far this year. Higher bond yields are hitting funding conditions and undermining equity market valuations.

- The ongoing slide in the US dollar is not, in theory, likely to jeopardise markets as the impact is essentially on financial conditions in the US, which is, in a manner of speaking, the principal market. And it is increasing leeway for central banks in the US dollar bloc which do not want to tighten quite as much as the Fed intends. However, following the Davos summit and Treasury Secretary Steven Mnuchin’s ambiguous comments - rapidly disowned by Donald Trump - questions are being asked about Washington’s exact intentions. Is the US dollar going to be used to restore the country’s external accounts or as a way of putting pressure on major partners during future trade negotiations? So far, protectionist measures like import duty on solar panels and washing machines have been purely symbolic. But there are significant challenges to come. Looking beyond the ALENA renegotiation, there are question marks over a US-China trade agreement. We think there is only a moderate risk of a trade war, but the issue might become important for various asset classes from time to time, depending on deadlines and circumstances.

Key points
  • Preference for equities rather than bonds
  • Overweight European and Japanese equities
  • Slight US dollar overweight

The recent fall in the US dollar is primarily due to:

(i) adjustments in the European yield curve as traders factor in the likelihood of the ECB tightening,
(ii) indications of a possible inflexion in the Bank of Japan’s monetary policy and
(iii) the sheer pace of flattening in the US yield curve, a move that could hinder the Fed’s pursuit of monetary tightening. We believe all these factors have now been discounted and are thus unlikely to push the dollar much lower. Clearly, the greenback could be hit by US political events, but it remains attractive as it still boasts a much higher yield than G10 currencies. As a result, we have maintained our slightly overweight dollar position in our portfolios.

We are keeping some power dry - by being overweight money markets- so as to be ready to reinvest in equities and/or bonds as and when. We remain underweight bonds: although yields have risen, we believe it is still too early to get back in. Equities look riskier to us since the surge higher (and subsequent rise in valuations) and we are maintaining our neutral weighting. Our favourite markets are still the eurozone and Japan.

    Our convictions for February Changes compared to the previous month
EQUITIES
US
Europe
  Euro
  United Kingdom
Japan
Emerging countries
FIXED INCOME
US
Euro
Investment Grade
High Yield
Emerging Debt (hard currency)
Financial bonds
Money market
DIVERSIFICATION    
Convertible bonds
Dollar
Next headline events
  • March 8: next ECB meeting
  • March 8 & 9: next BoJ meeting
  • March 20 & 21: next Fed meeting

Elément complémentaire