FX markets disrupt calm trading

Asset allocation strategy - 8/3/2017

The recovery continues apace and is now synchronised throughout the world judging from second quarter results in major zones which produced rather pleasant surprises as far as sales momentum was concerned. As a result, fundamentals are now underpinning risk assets, especially as there are in theory no clouds on the horizon in the coming months.

The euro is hitting European equities 

With asset prices looking more or less stretched, investors have been eyeing central banks. Valuations could undoubtedly be threatened by too big a shift in monetary policy. However, the Fed and ECB are being particularly cautious as inflation still remains soft. Their main message is that they will adjust policy to improvements in the overall environment so as to avoid being too expansionist, a long way from announcing a monetary tightening cycle. 

Tensions on bond markets have been mild in recent weeks which suggests this approach has gone down well with investors. But the euro's appreciation on currency markets has gone so far as to hit European equity performance. Assuming that bond markets remain free of risk, will US dollar weakness persist and will that disrupt market dynamics? 

In our view, the greenback has already discounted a lot of bad news and it should now return to normal trading levels: 

- The ECB has had a powerful impact but most of this is now behind us. Since Mario Draghi's comments in Sintra at the end of June, markets have been expecting tapering to be announced, probably at the ECB meeting in October. Today’s big question mark is the pace of the reduction in bond buying. Investors are also expecting interest rates to rise by 125bp over the next 5 years. Unless European inflation rises more sharply, it will be difficult for markets to expect much more from the ECB. Bear in mind that the 5-Year, 5-Year forward inflation expectation rate, a factor that the ECB used to justify the introduction of quantitative easing, is at 1.6% or much lower than during the August 2014 Jackson Hole conference at which Mario Draghi said he was worried it would drop below 2%. 

- The Fed continues tightening. Markets have barely factored in one hike before the end of 2018 while FOMC members expect four on average. Previously, any Fed tightening automatically triggered a rise in the US dollar and thus tougher lending conditions in the US, a pattern that often led the Fed to deliver less than indicated. But the US dollar has lost 7% over the last 6 months even though the Fed has been preparing investors for a reduction in its balance sheet as well as further rate rises. This means there is a good chance that this time the Fed will tighten more than investors expect, a move that would be good for the dollar. 

- Markets have already factored in political changes in the US and in Europe. Since the first quarter, markets have wiped out most of the gains that followed Donald Trump’s election. But the current stalemate in Washington no longer looks capable of having a significantly negative impact. Similarly, investors have discounted reduced political risk in Europe following Emmanuel Macron’s election. This political shift has definitely had a positive effect on the euro but the uptrend cannot be extrapolated. Following the failure to reform healthcare, the US Congress is now more determined to cut taxes ahead of the mid-term elections, a mood that could help break the current standstill. In Europe, political risk looks more balanced. On the one hand, there are hopes of fresh European initiatives to reinforce and relaunch the eurozone once the German elections are over. On the other, there is still some justifiable apprehension ahead of the upcoming elections in Italy with no certainty over the exact date or over the outcome. 

- Investors have already massively bought euros. A number of surveys show that investors have already massively sold US dollars to buy euros which is one less reason for further rises in the euro. 

Our asset allocation is unchanged. We are slightly overweight equities, particularly in the eurozone and to a lesser extent in Japan, and underweight the US and emerging countries. We have taken advantage of very low volatility to hedge part of our portfolios against unforeseen events. On bond markets, we are still cautious over duration risk and more selective over corporate debt but continue to favour financial bonds. We increased US dollar exposure a little last month and are sticking with these positions.

    Our convictions for August Changes compared to the previous month
  United Kingdom
Emerging countries
Investment Grade
High Yield
Money market
Convertible bonds
Next headline events
  • September 7: next ECB meeting
  • September 19/20: next Fed meeting
  • September 20/21: next BoJ meeting

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