Although global markets have been enjoying a bullish run over the last two quarters, they have become more subdued given a political backdrop and economic policy uncertainty from the US, Europe and Japan. Nonetheless there seems to be a renewed enthusiasm for a better, more business friendly environment, especially given promises of more deregulation, especially in US financial markets, but also from less stringent governments in the EU tilting it to a more nationalistic, popular and closed border political environment that suggest a pivoting towards internal demand pro-growth policies and a relaxation of strict government and bureaucratic regulations, placing the Euro area on more shaky institutional grounds to forcefully implement fiscal coordination between core and peripheral countries.
Equities
Equity markets have been enjoying a reflationary rally period that is uncommon following the election of a US president and this bullish sentiment has pretty much lifted all boats. However, different sectors have been more beneficial than others, with Financials and Materials leading the pack until the end of 2016. A more subdued quarter has followed, with investors feeling a bit more cautious and less optimistic on the stimulus package, tax reform and deregulation. Despite this appeasement in sentiment, there seems to be complacency in equity valuations across mayor sectors, with technology running at high valuations, followed by health care and consumer discretionary.
Financials have taken a backseat as most of the increase was due to the potential reflationary effect on the yield curve and a boost to the economic activity promised by this new US administration, but we have a neutral weight due to a higher growth expectations backdrop but a more subdued slope in the yield curve.
On the contrary, given the recent struggles and later failure to repeal the Obamacare law, the health care sector has regained some strength lately, although we don’t know the real net impact of any repeal and replace efforts on the overall healthcare sector. The pharma and biotech industry might take a hit given a potential regulation that might stop future drug price increases and renegotiation of Medicaid/Medicare prices. On the health insurance sector, even though any repeal and replace plan might lower the insured population, the lower health coverage costs and better suited premium plans, especially for the middle class, and reduced costs associated with lower bureaucracy that state exchanges currently have might bring a relieve for this industry as well as expand generic drug sales for pharma industry. Therefore, we still remain a bit underweight
Energy sectors will still be burdened by supply pressures and restrained demand from China, Japan and Europe. We are underweight. Materials will definitely benefit from the current reflation stage so we are overweight this sector.
Technology and Telecommunications might see a more restrained period given hefty valuations in this mature cycle given that any reflationary effect will impact less their growth strategy and their tremendous supportive momentum it’s been for the past two quarters. We remain therefore neutral on the sector.
European cyclical stocks offer more attractive valuations on a non-hedged basis but we see major headwinds in the euro area that could hit euro denominated investments for US dollar investors. Japanese stocks might offer better risk adjusted returns given the Yen depreciation of the last six months for export driven companies, but might be neutralized by any euro weakness coming in the next few months. We remain supportive of at least a 10% allocation to developed equities.
Rates
After the latest Fed hike on March 15, bond markets have a reason to be concerned. Not only because it will put pressure on high yields and emerging market bonds, but also because EU and Japan government bonds could feel the pain as well, as investors will shift strategies to higher yielding US treasuries. This however is putting a lid on longer treasury yields and might not get the full benefit of a more “normal” yield curve. And here is where my view is in line with those warning for a flattening of the curve, hurting the banking sector, especially if the fiscal stimulus from the US does not materialize on time. If we continue to see a drag in EU and Japan inflation and economic activity, we might see continued downward pressure on US treasury yields. Thus, although recent sell offs from mid-2016, the reflation driven momentum needs to be taken with extreme care for any sudden move in the anchored inflation expectation already set in by the markets could disrupt the low volatility environment and overshoot yields back down below 2% in a short period of time. Without creating a “tapper tantrum” scenario like in 2013, the Fed has increasingly warned the markets of aggressive hawkish move, although reiterating its stance of data dependency rate trajectory. But markets have been fooled for the past two years, and this time around it has been putting downward pressure on this forward guidance. Without any mayor hiccups in the current US administration efforts to start implementation of the currently proposed changes in the fiscal and regulatory fronts in 2017, 10yr Treasury support could very well be at around 2.50% for the remainder of the year. If the fiscal stimulus measures get dragged, my most predictable scenario, we could be looking at a 2.50% resistance on these bonds. All in all we remain bearish and underweight in US sovereign debt.
In Europe, things are a bit different although lately on the same direction. The ECB has taken a wait and see approach, in contrast with an all lose policy for the last three years, as inflation and activity start to show signs of sustained strength. However, significant risks await the area for the next two quarters, especially on the political front in France and Italy, as well as fiscal pressures in Greece, among other peripheral countries. So we view the next quarter as critical in any ECB decision on the direction and strength of the move. We are overweight in core Euro sovereign and neutral to underweight in peripherals as we believe these risks will add volatility to the markets. These same risks can affect the BOJ’s zero rate policy which may come under pressure, so overweight in the sovereign 10yr JGBs.
Credit
We see sustained strength in the investment grade credits, as we see a continued trust and belief in the incoming fiscal policies will support growth, therefore we remain neutral. We are increasing our weigh in short duration senior secured loan due to increased prospect of continued rate hikes by the Fed. We are however less bullish on high yields as the spreads have become a bit rich and have a lower tightening cushion to go, therefore making them have a lower expected adjusted return compared to equities. We’ve become underweight on subordinated debt.
Currencies
The US dollar has become the most badly forecasted market of all asset classes in the post-election risk market rallies, with almost everyone calling for an ever stronger dollar, especially after promises of tax adjusted US trade policies, fiscal stimulus, deregulation and more hawkish rate path from the Fed. However, after these efforts take time to materialize, investors are starting to fade out their bullish dollar bets. This reversal has put support in other developed currencies the Yen, Euro and even the Pound. It has also been supportive for commodities, especially in energy and industrials. Gold, which has been punished in the initial reflationary risk assets’ rally, has been recovering some ground on the renewed US dollar weakness.
We see EURUSD under some downward pressure in the mid term, possibly down to parity if political risks in the euro area materialize, as well as in USDJPY given US pro growth efforts fading out and potential increased global trade disputes and uncertainty.
Regardless of this central bank policy divergence among developed regions and the potential for some spike in risky asset volatility, carry trades still make a lot of sense for yield pick up in portfolios' shorter duration allocations.
Commodities
Even though gold has recovered on the back of US dollar weakness, it has been on a range bound the first quarter of 2017. Given our forecast of USD strength for the next quarter, we see it trading range bound so we are neutral.
The oil markets have been more volatile given OPEC countries’ commitment to curtail production in 2017 but encountering a strong, reactive and nimble US shale producer supply response which is putting a strong resistance on any short term trend. Natural gas inventories have had the same run given a mild winter in the northern hemisphere. Having consider this we turned bearish and underweight our position.
We remain bullish on copper as it might benefit strongly from the infrastructure stimulus coming from the new US administration, especially with mayor mine shutdown problems resolved for the time being.
We are neutral on soft commodities as softer demands from China, Europe and Japan, might be neutralized by shorter supply given warmer weather affecting crops on global regions.
Emerging Markets
Given the waning effects of the reflationary trades, investors started looking for other catalysts to support their bullish views. As such, global investors have been shifting their allocation towards cyclical and more sensitive sectors, like technology, discretionary and EM markets. The latter was especially hard hit right after the US election. However, this erosion of confidence in clear and strong fiscal and trade policies from the US government, has put the attention on cheap EM assets, especially currencies (mexico and brazil), as well as stocks and bonds.
Having said this, emerging market equities have also rallied on the back of a supportive potential US economic growth, however though a China deceleration, inward driven market reform and a more restrictive monetary policy are hampering any strong industrial metal and soft commodity market bullish momentum, making equities very sensitive to what future Fed actions and US fiscal policies will have on the US dollar. Even though, the space has rallied lately, you need to be selective as, for example, Mexican shares might now underperform other BRICs shares given a NAFTA partial unwinding. As we are cautiously optimistic on the sector, we are neutral on the space.
Interestingly enough, high yielding carry trades in EM currencies can present decent low risk opportunities. A small allocation should complement a short duration, money market position in a portfolio. Brazil and Taiwan are present interesting net yield/swap spreads.
Alternatives
Given richer equity valuations in the US, and the waning down of pro growth new US policy enthusiasm, sector performance will become less correlated between them, and potentially more disperse, providing opportunistic entries for Hedge Funds in selective sectors, industries and strategies. We are neutral on Real Estate (commercial and residential), given a hot market in many parts of the US, but a lack of the appropriate income/wage growth to support it as well as a rising interest rate environment. Private Equity can make a lot of sense given the resurgence of M&A activity.
