Investment Outlook 05.2017
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
French elections calm concerns about Europe’s stability
Global equity markets performed strongly in April. Emerging markets continued to outperform with a 2.0% gain vs. a 1.3% gain by developed markets. Also, Europe continued to outperform the US; the MSCI Europe rose 1.3%, the MSCI Eurozone even went up 2.0%, and the S&P500 index 0.9%. Japanese equities did well, rising 1.5%, but remain in negative territory year-to-date.
Government bond yields did not move much in April and stayed range-bound. Only US 10-year yields moved more significantly, falling 11 basis-points.
Risky bonds, like emerging markets and high-yielding bonds, performed strongly in April.
Interestingly, and despite better growth, commodity prices came under pressure. The price for Brent oil fell by 3.4% in April and is down 11% from its level at the beginning of the year. We believe the oil price has potential to recover since capex spending has been reduced in recent years, which should help to stabilize and increase oil prices. The gold price rose 1.5% in April.
Global REITS lost 0.9% in April. European REITS; however, clearly outperformed and rose 3.1%. We remain neutral on REITS, which should benefit from global growth since rents tend to rise in such an environment.
We saw a remarkable recovery of the EUR in April and early May, certainly helped by reduced political risk in Europe after the French elections. Short-term we see potential for the USD to recover, since the Fed is likely to raise rates in June and probably again later this year. However, should the ECB start to taper in a more meaningful way, the EUR could strengthen more significantly. The CHF could weaken somewhat, especially after the French elections, as a result of the broad-based EUR strength.
Macro fundamentals remain very positive, although we saw some divergence in April. The European PMI continued to advance, but the US ISM index retreated somewhat. The European PMI climbed to 56.7 after 56.2. The US PMI fell to 54.8 after 57.2. Both indicators still signal strong growth of the manufacturing sector, since they have stayed above the 50-mark.
This was further confirmed by strong US non-farm payrolls, which rose by 211,000 in April after 79,000 in March. This in turn reaffirms ongoing job creation in the US and will further tighten labor market conditions. So far, however, wage pressure seems to be muted, since e.g. average hourly earnings are steadily growing at a moderate pace of 2.5%.
Headline inflation in the US declined somewhat to 2.2%, since energy costs have fallen recently and the base effects in the energy sector are petering out. Eurozone inflation was 1.9% in April.
Inflation expectations, as measured by 10-year break-even rates, continued to drop.
On 3 May the US Fed met and, as expected, reiterated its policy stance. We consider it very likely that the Fed will raise rates at its 14 June meeting.
There is debate about when the Fed will start to reduce the size of its balance sheet. The balance sheet has grown from USD 900 bn before the financial crisis to USD 4,5 tn. Since asset purchases ended in October 2014, maturing bonds have been reinvested to maintain the size of the balance sheet. It is expected that next year the Fed may announce reduction of its balance sheet, which would have the potential to worry markets.
At its policy meeting on 26 and 27 April the ECB left rates unchanged. The directors have been divided on whether the growth outlook should be described, as hitherto, as “… downside risks to growth still prevail …” or changed to “balanced” with its more positive connotation. It is possible that the ECB, at its 8 June meeting, will change its communication to reflect a more positive outlook for the economy. This could also imply that in autumn more meaningful tapering could start. The ECB already reduced its monthly bond purchases from EUR 80bn to EUR 60 bn.
Meanwhile, the debate around the succession of ECB chairman Mario Draghi has begun. While his tenure will last until 2019, German press articles – without disclosing any source – wrote that Chancellor Merkel was pushing for the President of the German Bundesbank, Jens Weidmann, to be Draghi’s successor.
Our outlook remains broadly unchanged. We still favor risky assets and prefer equity over bonds. Within fixed income we prefer high-yield and emerging bonds, but maintain our natural positon, since valuations have become rich.
Within equities we prefer the European and Japanese markets. We maintain our Japan overweight but decided to take profit on our European equity exposure and reduce the positon to neutral.
We have become more positive on oil and energy prices and built an energy overweight position within the commodities allocation.
We are rethinking our preference for the USD. If the ECB were to announce more meaningful tapering, the EUR could continue to stay on the strong side. Overall, we do not think that the EUR-USD exchange rate will break-out of a range between 1.05 and 1.15 this year. Short-term, on the back of the next Fed rate hike in June, we expect the USD to regain some strength, however.
In our view, while the GBP looks very cheap, we expect it to stay under selling pressure. The UK elections on 8 June will – in our view - strengthen the position of Theresa May’s government. The exit negotiations with the EU will prove to be very difficult and controversial and since the EU has no incentive to take a soft stance on the UK, we expect uncertainties to rise. This will weaken the GBP, especially since the UK economy exhibits a large current account deficit.