Europe has regained its lustre

Investment strategy - 7/7/2017

Markets are worried about inflation levels and fresh falls in oil prices during the spring months. They have doubts about the solidity and sustainability of the US recovery and are hanging on every central bank statement. In short, they are looking for new market catalysts.
Philippe Uzan 

Philippe Uzan

Chief Investment Officer
Edmond de Rothschild Asset Management 

Our investment strategy for the second half of 2017

  • Allocation: focus on equities at the expense of bonds and zones likely to see strong earnings growth
  • Equities: overweight the eurozone, underweight the US
  • Bonds: spotlight on subordinated financials. Avoid interest rate risk

Financial markets saw strong momentum in the first half of 2017, mainly due to the end of major political uncertainty and upbeat economic indicators. As we move into the second half, investors are in wait-and-see mode. However, continental Europe is a case apart. It still has robust fundamentals and a number of economic and political tools to hand to win back investors.  

The monetary environment is a little more uncertain

The global recovery is proceeding apace. Recent trends suggest it has stopped accelerating and is now undergoing a temporary and very slight downturn. The recovery has become broad-based across the three continents and nothing seems likely to seriously undermine the trend. Inflationary pressures have, however, abated in developed countries. In the eurozone, core inflation is still rather low and it has slowed in the US over the last three months.  

For a change, the biggest surprise in recent weeks has come from a shift in tone from almost all G7 central banks (the US, the eurozone, the UK and Canada, but not Japan). For markets, of course, the Fed and the ECB are the ones to watch. The reasons for this more hawkish tone in spite of inflation disappointing once again are varied but all the banks concerned are delivering practically the same message. 

Monetary policy must gradually adjust so as to avoid becoming over expansionist.

To differing degrees, Janet Yellen and Mario Draghi think monetary policy must gradually adjust so as to avoid becoming over expansionist; the recovery is gaining traction and demand is robust. This central bank signal is potentially worrying for markets which had already factored in a sharp fall back in last year’s reflation hopes. Generally speaking, accommodating monetary policy has encouraged investors in recent years to take risks in the search for returns so any change is likely to create short term volatility.

That said, the Fed has so far been very pragmatic, modulating tapering moves as well as monetary tightening in line with economic shifts. It is now hard to imagine that it will act differently if inflation continues to move off course. Mario Draghi, speaking in Sintra, insisted that the ECB would be very careful to adjust its monetary stance to help the recovery. As a result, the ECB in 2018 will probably start gradually slowing its bond buying programme, a development that markets have already priced in. At this stage, we are unwilling to extrapolate this signal as we are not convinced it gives a meaningful indication of future Fed and ECB action.

European equities get even

Old Europe fell victim to a political premium but resisted the populist wave and is now back in favour with investors. Although elections in Italy and Austria could occasionally cloud the horizon before the end of 2017, the outlook is now particularly clear. Germany’s upcoming elections pose no threats at this stage and the Franco-German axis seems determined to return to its role as Europe’s driving force.

The lifting of political risk has occurred at a time when the recovery is gaining strength

The lifting of political risk has occurred at a time when the recovery is gaining strength: Germany’s IFO survey hit an all-time high in June. Company margins have started to recover after suffering for a long time and still have the potential to improve. Earnings growth momentum has also started to accelerate for the first time since 2010. At the same time, European equities are trading at relatively attractive valuations compared to US stocks or other asset classes, notably bonds or certain property assets.

Midcaps are particularly geared to growth and so could benefit from the European upturn. These are often companies with strong innovative and value creation edge. And now that France’s presidential and parliamentary elections are behind us, domestic stocks, hitherto held back by doubts over the ongoing improvement, are free to perform well. Banks, construction and mass retail stocks are once again centre stage.

"Elsewhere, companies are facing huge challenges which are forcing them to embrace fundamental changes by reviewing their business scope, critical mass and their ability to dictate prices."
Phillipe Uzan

Elsewhere, companies are facing huge challenges which are forcing them to embrace fundamental changes by reviewing their business scope, critical mass and their ability to dictate prices. This resulted in a sharp increase in M&A deals in the first half of 2017. Total deal volume was above €200bn, the highest level in 10 years. The trend encompasses all sectors and all capitalisation sizes. France is among the most active markets now that reduced political risk has lifted the cloud hanging over Europe’s M&A cycle. Low interest rates are also an encouragement while rising equity markets and reduced volatility have helped stabilise valuations to a degree.

We also think Japanese earnings have significant rebound potential, even more so than in Europe. Margins there could recover and help boost earnings momentum. At the same time, Japanese equity valuations are still rather attractive. There are also signs that the recovery is deepening while a trend towards gradual reflation appears to have taken hold.  The government is mulling budgetary measures which could result in a more structural recovery and the labour market has become so tight that wage pressures should finally resurface. Elsewhere, we have taken tactical profits on emerging country equities after very strong year-to-date performance. We are also underweight US equities. The Trump administration has so far failed to introduce sweeping fiscal reforms so it looks very unlikely that company margins will improve in coming months.

An all-purpose approach to bond markets

There are still numerous opportunities on bond markets but, as in 2016, it is vital to maintain a flexible and selective approach to segment allocations and issuer selection in the riskiest areas.

Yields on top-rated government bonds are still excessively low and offer little, and sometimes no, protection against even a slight rise in interest rates. The surprising drop in 10-year US Treasury yields during the spring period has led us once again to turn cautious on US bond duration. The situation is even more pronounced in Europe for German and even French bonds which in our view clearly present asymmetric risk at the expense of investors.

Of course, yields which are much lower than their historic mean are warranted by the absence of inflationary pressures despite the cyclical recovery and the ECB’s ongoing accommodating stance. Nevertheless, in the autumn, Mario Draghi will probably announce a gradual slowing of the QE programme for 2018 and that would justify incipient normalisation in the coming months. On European credit markets, spreads on top-rated companies are also very tight and also to some extent dependent on ECB declarations. We are consequently staying clear of this segment. In high yield, carry is still a theme but the potential for yields to tighten further looks limited to us.

Subordinated financial debt is still our favourite theme for the second half of 2017

Subordinated financial debt is still our favourite theme for the second half of 2017: both the regulatory environment and the ECB’s policy are good for the segment. These bonds are particularly sensitive to political risk in the eurozone so the recent lifting of uncertainties offers interesting prospects. Investors can now concentrate on issuer solidity; thanks to lower systemic risk and better bank solvency ratios, it has improved significantly in recent months. Moreover, valuations are still reasonable. Note also that subordinated financials would prove defensive if tensions were to rise on core country debt. Rising interest rates are rarely good news for bond markets but they are, in fact, favourable for financials and subordinated financial debt would thus outperform other bond segments.

This analysis is an extract from the first House View published by Edmond de Rothschild. 

This publication presents Edmond de Rothschild’s key convictions for macroeconomics, asset allocation strategy, and the principal asset classes. 

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