Waiting for the Fed to spring into action

Cross asset strategy

The US central bank is now confronted with divergent economic indicators that are jeopardising the decision to continue the “normalisation” of its monetary policy. In fact, the main US macroeconomic indicators show that the economy has rebounded after a weak first quarter and that the unemployment rate is low. On the other hand, however, the latest nonfarm payroll data were relatively disappointing and both the inflation rate and wages growth are still low.
Furthermore, the current devaluation of the Renmimbi could raise concerns about the currency equilibrium around the world and especially about its impact on the USD and consequences for the US economy and inflation.

As long as this devaluation is contained and does not endanger current fundamentals, we think that the US central bank can nevertheless afford at least a first hike in H2; the rebound of the economy justifies this second step, following the normalization of the financial conditions and, given the global context of abundant liquidity, the Fed would not be taking too much of a risk. However, even if the consensus also expects a first move from the US central bank this year, there is no strong majority on when this first rate hike can be realised and as to whether there could be a second one by the end of the year.

Contrary to the US, almost all other regions are in “easing” mode. Indeed, the ECB and the BoJ have maintained their massive bond purchasing programmes (EUR 60bn/month and YEN 80trn/year respectively) and emerging central banks (even in China) have also eased monetary conditions in recent months (see chart 3).

We are thus convinced that liquidity will continue to be abundant and to support risky assets. When the Fed eventually proceeds to its first rate hike, it will do so very cautiously and gradually.

REGIONAL EQUITY STRATEGY

Strong earnings season in the euro zone

From a fundamental point of view, equities remain more attractively valued than bonds. Euro zone equities made the difference compared to US ones during the earnings season.

Strong overweight on euro zone equities

Soon after Greece and the European Union reached a temporary agreement, we increased our exposure to euro zone equities again. As mentioned in our latest communications, this deal allowed us to decrease the risk premia for euro zone equities, especially those in the peripheral countries. We now have an overweight of 6% on this asset class, with a tactical overweight on the Spanish Ibex and the Italian MIB and a slight underweight on UK equities.

We think that euro zone equities, especially Italian and Spanish equities, will continue to benefit from the weaker euro, the low oil prices, the firmer economic recovery we expect in the area and greater expected earnings growth. During the Q2 earnings season, euro zone equities also made the difference by strongly beating expectations in terms of earnings but mainly as regards sales figures, while more than 50% of US corporates – penalised mainly by weak results in the energy sector – missed sales expectations.

Furthermore, as the ECB is continuing its quantitative easing, euro zone equities will still be more attractively valued than US equities when compared to bonds.

Finally, we have increased our exposure to euro zone small caps, as they may benefit from better earnings growth, an environment in which volatility is contained (cf short-term agreement on Greece) and more attractive valuations than large caps.

Neutral on Emerging Markets

After selling our position in Chinese equities in equities in June, we continue to watch closely the evolution of the situation and prefer to wait for a stabilisation before reconsidering an overweight on this asset class. Globally, latest economic data on emerging countries continue to point to subdued growth, particularly when regarding the weaker industrial production in Asia.

In this context and despite appealing apparent valuations on the asset class we have maintained our neutral exposure to emerging market equities. Earnings growth will be weak this year and dispersion continues among the various emerging countries, sectors and individual stocks.

Still positive on Japan

We have kept our positive stance on Japan as Japanese equities remain supportive for the same reasons

• more attractive valuations and the additional BoJ measures should trigger a potential increase in earnings;
• investors’ expectations of a substantial future increase in shareholder returns, helped by solid earnings growth and strong cash holdings.
• the change in the asset allocation of the GPIF, Japan’s leading pension fund, which is indicative of the sustainable support for Japanese equities.

FIXED INCOME STRATEGY

We have maintained our short duration and our preference for more diversification towards Emerging Markets and High Yield bonds

While the Fed is close to increasing its interest rate, we are underweight in government bonds as there is less of a cushion to absorb any increase.

We also continue to diversify our bond portfolio to riskier, higher-yielding bonds, which continue to benefit from the combined actions of the ECB and the BoJ (both of which are easing their financial conditions) and from the fact that, even if the Fed does proceed to its rate hike, it will certainly act cautiously in its management of the interest rate increase.

Regarding our emerging debt investments, we continue to favour debt denominated in hard currency vs. local currency. In the High-Yield environment, we are focused on strong selectivity.

COMMODITIES STRATEGY

Close to capitulation level? Uncertainty remains

Although the commodity index is globally under its 2009 level, concerns remain and execution risks are too present to now turn positive on the asset class.

Oil: we remain cautious. While US production has slowed down, the OPEC countries have increased their production (see chart 4). Moreover, after Iran and the six world powers (UN Security Council plus Germany) reached a historical agreement, Iranian oil could now accentuate the current oversupply. As stocks remain at high levels, we think the repricing will be long.

Base metals continue to be penalised by the disappointing activity in the Chinese and, globally, the Asian, manufacturing sectors. Nonetheless, as long as the Chinese government succeeds in managing a soft landing of the economy, the oversupply problem should be resolved for some base metals such as copper, zinc and nickel, with supply shortages from 2016-2017. We prefer to wait for stronger signs of better economic growth in China to invest in this asset class.

Finally, gold prices are negatively correlated with US real interest rates. Prices have also been penalised by weaker gold purchases from India and the Chinese central bank.