Mixed economic newsflow in China and the US

Cross-asset strategy

Softer PMIs were registered for both China and the US, pointing to a contraction in the manufacturing sector of the two largest economies for the second month in a row. In the US, both the New Orders and Export Orders components are, however, picking up, which is a positive, as both are leading indicators of the overall survey. Further, US consumer confidence, supported by a booming labour market, remains supportive. In 2015, the US economy added 2.6 million new jobs. This represents the second-biggest yearly increase since 1999, after the 3.1 million rise registered in 2014. Looking forward, the resilience of the service sector will remain paramount if US expansion is to continue.

Developments in China driving markets

Early-2016 has been dominated by two factors that have been driving markets for several months already: China and Oil. While Chinese fundamentals continue to point towards a rebalancing of the economy, with a declining importance of the manufacturing sector, conflicting communication on stock-market regulations and the increased volatility of the Yuan exchange rate have eroded market confidence. While Chinese market valuations are attractive, even excluding banks, this is not yet sufficient enough a criterion to increase investments in Chinese equities. The ongoing depreciation of the Yuan vs. USD since the introduction of a CNY trade-weighted index of 13 currencies on 11 December, 2015 has led to renewed market concerns of a Yuan depreciation, increasing deflationary pressures outside China and fuelling growth fears globally. A rough estimate puts the downward impact of the CNY depreciation on global price inflation at -0.3% for 2015.

Falling oil prices adding to deflationary pressures

The macro picture for the price of oil is poor as the energy markets continue to struggle with a series of headwinds, including doubts about the global growth environment and excess supply (96.5mb/d vs 95mb/d demand). In this regard, the softening in the Chinese and US manufacturing surveys has increased downward pressure.

US oil production has started to decline, whereas any consensus to limit OPEC production is unlikely to emerge anytime soon, given the political escalation between Saudi Arabia and Iran. As a result, oil prices have fallen further, postponing any significant recovery in producer and consumer price inflation.

Amounts of shrinking Forex reserves equivalent to liquidity-tightening

The indirect effects of the fall in the price of oil and the Yuan weakening are likely to withdraw liquidity from the global financial system as the recycling of the petro- and sinodollars comes to an end. Based on the prevailing trend observed in recent quarters, liquidity-tightening via shrinking Forex reserves would amount to roughly USD55bn per month. Given the most recent declines in Forex reserves (USD108bn for China in December 2015 and USD12.4bn for Saudi Arabia last November), our estimate appears rather conservative. As a consequence, renewed monetary easing (or less tightening) by the major central banks is becoming a distinct possibility for the coming months to alleviate deflationary pressures.

REGIONAL EQUITY STRATEGY

Euro zone equities remain our strongset conviction

Overweight on euro zone equities

As mentioned above, the region continues to deliver better economic momentum and looks more resilient than the US or UK economies to global growth concerns. Domestic demand is picking up as a growth driver. Clearly, the drop in energy prices will continue to support both households’ purchasing power. Further, liquidity conditions continue to be supportive in the single-currency area, as the ECB continues its asset buy-back programme.

We expect publications in the upcoming earnings season to be stronger in the euro zone than in the US. Earnings are being revised down but Q4 EPS should grow by +9.4% yoy and even post +14.6% growth ex-Energy according to consensus estimates. In the US, earnings expectations have been cut significantly since October and are now expected to fall by 4% and be almost flat ex-Energy.

In this context, we are comfortable in maintaining an overweight stance on euro zone equities while continuing to underweight UK and US equities. We have also maintained our overweight on European small-cap equities in order to benefit from domestic demand.

Neutral on Emerging Markets, exiting the tactical overweight on Chinese equities

Emerging markets’ valuation is declining further and is now well below its 2008 level. The region will continue to be considered a value trap until we have clear signs of a stabilization in growth anticipations. Given the current recessionary backdrop in many emerging markets and the expected long-term earnings growth, valuations – in our view – are not that attractive. We maintain a neutral stance on the region.

While valuations of Chinese companies remain attractive, both in absolute and in relative terms, compared to other emerging markets, we have decided to cut our tactical overweight on China. Repeated market intervention at the turn of the year has eroded confidence. While both the IPO freeze and the rule requiring brokers to hold net long positions have been lifted. The expected end of a ban on share sales by major shareholders (holdings in excess of 5% of a listed stock) has been anticipated for the first week of January and has been finally extended beyond 8 January.

Further, the introduction of a new circuit-breaker system created panic among retail investors once the initial -5% threshold was hit. Given the disastrous track record (trading ended early twice in just four days), the regulator decided to drop the new rule at the beginning of 2016.

Neutral stance on Japan

In our view, liquidity support is still there as the BoJ continues to inject 80tn JPY/y and corporate profits remain a tailwind.

We nevertheless remain vigilant, as the Japanese Yen is rising in a risk-off environment and we continue to monitor the uncertainties caused by emerging countries, Japan being one of the economies most exposed to these countries.

Overall, we have reduced our exposure from slight overweight to neutral.

FIXED INCOME STRATEGY

We are keeping a short duration and diversifying further

The Federal Reserve did finally hike its Funds rate for the first time since June 2006 on 16 December. We are still underweight in government bonds as there is less of a cushion for absorbing any increase. We have also maintained a below-benchmark duration.

On the other hand, we continue to prefer diversification away from government bonds to US investment grade corporate bonds (hedged in duration), high yield and emerging debt, based on valuations, as attractive yields give some comfort in an adverse scenario.

We have kept our exposure to the US dollar unhedged.

COMMODITIES STRATEGY

Acceleration in the oil-price drop

In spite of sharp declines in commodity prices at the turn of the year, the signals have not been strong enough for us to turn positive on the asset class.

Oil: The macro picture for the price of oil is poor, as energy markets continue to struggle with four headwinds: Fed tightening, record inventories, doubts about the global growth environment and excess supply (96.5mb/d vs 95mb/d demand). In this regard, the softening in Chinese and US manufacturing surveys is increasing downward pressure while the escalation in the Middle East implies that OPEC will not find any consensus-based decision to cut supply anytime soon. As a result, the price of oil (Brent) is now down over 70% from the levels seen in June 2014 and 50% from its peak in May 2015.

The micro picture looks somewhat better, as US shale production is declining (-0.3m bbl/d since May 2015) and a healthy US job market is a positive catalyst for the summer driving season. Looking forward, the rebalancing of the oil market via further declines in US oil production, sustained demand from the developed markets and an unsustainable strategy for oil-producing countries (in particular Saudi Arabia), should eventually lead to a bottoming-out of the oil price.

Base metals continued to be penalised by the contraction in the manufacturing sectors in emerging markets and the US. For base metals such as copper and nickel, although the efforts made to adjust production downwards could support prices in the coming years, economic stabilization in the emerging markets is a prerequisite.