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17 Aug 2017

Q3 2017 Outlook: Should you believe in fairytales?

 

Once upon a time in the West...  

So, where to begin? Macron’s march, May’s misery, Corbyn’s calamitous maths or Trump’s travails? Nothing is certain it seems in politics these days. Yet continued central bank support means bond and equity markets alike have largely taken it in their stride. Can the fairytale continue?

 

Hidden by headlines

About the only thing that isn’t overheating in the US right now is the economy. Sub-2.5% GDP growth allows the Fed to tighten “only” moderately, which is a burden for the dollar and a trigger for risk-taking elsewhere. And it comes at a time when economic growth in the euro area and Japan is accelerating and China’s policies remain supportive ahead of a potential leadership reshuffle at the all-important 19th Party Congress in the autumn. It all points to equities over bonds. 

The expected pre-summer acceleration of the US economy should also boost commodity prices. Closer to home, some Brexit pain is all but guaranteed. Consumer confidence could be dented and UK assets, especially sterling, could come under renewed pressure.

 

O ye of little faith

Some of the optimism over Trump’s spending plans has evaporated, rather like the detail, as overly positive soft data finally became decent hard data. Despite his seemingly daily struggles with Congress, we expect parts of his economic agenda to make it through, notably proposed tax cuts for individuals and businesses. Tax cuts are vote winners, so looming 2018 mid-terms will force the issue. There are other “wins” on the horizon as well, including the Treasury’s bold bank de-regulation plan, and revised health care legislation.  

Whether long-term success is likely is another question. Trump’s turbulent apprenticeship on the Hill is a strong incentive to diversify into regions where structural reforms have been implemented and are bearing fruit: the eurozone, Japan and, to some degree, those emerging markets which are seeing a recovery in their balance of payments.

 

Events to watch out for in H2 and beyond

 

Events to watch out for in H2 and beyond

*Lyxor CAR, July 2017.


Confident on commodities

The stronger global growth pulse could steel commodity prices, and finally tip the supply/demand balance in their favour. Should assets be less influenced by the dollar story and more by fundamentals, commodities - especially energy and industrial metals - stand to benefit from stronger economic growth in both developed and emerging markets.

OPEC attempts to curtail oil supply and therefore lift prices have to date been hampered by US shale production, but rig count should decline in H2 as weaker prices erode profitability. Wait for the right entry point. Copper prices, which have also been held back by oversupply, should climb as production capacity becomes more constrained.

 

Emerging into the light

The key external drivers for emerging markets – a tame Fed, a soft dollar and China – should linger for a while yet. Meanwhile, external vulnerabilities have receded, and growth prospects have improved. Be selective however, momentum is strong and valuations are already rich. Local monetary policies aren’t quite as supportive as they were. 

 

Advocating Asia

We still like Asia: valuations are not so stretched, earnings are recovering and liquidity conditions are supportive. We are however concerned about China’s financial stability, especially with the spectre of shadow banking rearing its ugly head again. Instead, we favour markets like Korea, where recovering earnings and fresh political leadership are set to revive the rally. Taiwan too is supported by better earnings prospects, foreign inflows and a turning in the electronics cycle. 

India also appeals, but lacklustre earnings growth could impede performance in the short term. In Japan, we favour small-caps because of their greater sensitivity to domestic economic improvements and their lesser sensitivity to movements in the yen.

 

Lift off in Europe...

Data seems to have turned in the eurozone. No longer is the region numbed by persistent pessimism; these days, investors are being wooed by rampant recovery. Growth is taking off, labour markets are mending and the credit cycle is expanding. All risk assets look attractive at this point, most obviously the sectors most closely linked to the recovery. We favour construction, consumer discretionary and banks. 

A caveat: inflation is still dormant. Regardless, the ECB can’t sit on its hands enjoying the sunny glow forever. Winter is coming – probably in the shape of €40bn per month fewer purchases throughout the first half 2018. Rate hikes look more distant. We’re idling in neutral on government bonds for now. Longer-term, we’re not confident on their outlook, but many have called the end of the bond bubble before us and we’re still waiting. Such is life.

...left out in the UK

Brexit negotiations are under way, and it’s already clear the path will be anything but smooth. We think people are being unduly complacent about the risks to growth. In our view, GDP growth will slow from 1.6% this year to 0.8% next. Inflation meanwhile should progress from 2.6% to 2.9% by year end 2018. This rise, and the acute uncertainty accompanying the Brexit talks, will hit consumption and weigh on activity. Although sterling has depreciated a lot already, we’re not sure the floor is in sight yet. 

 

Our key calls

United States

Commodities EM Japan

Eurozone UK

Gold

  • sU/W US Treasuries
  • Neutral S&P with defensive themes
  • O/W Growth vs. value O/W Minimum Variance
  • O/W Domestic vs. Global
  • U/W Small vs. Global
  • O/W HealthCare products & services
  • Neutral US High-yield for now. Lt negative
  • USD ST upside potential
  • Brent to end up in a $47-55 range
  • Tactical Buy Copper
  • Long Korea, Taiwan & India vs. China
  • Neutral EM debt: Prefer Argentina, Colombia, Indonesia
  • Neutral JP debt
  • Japan equities: prefer Topix small to Topix 100

  • Neutral on EMU Govies, turning negative
  • sO/W French OAT vs, German Bund
  • O/W Euro equity
  • sO/W Construction
  • sO/W Discretionary vs. Staples
  • Tactical Long Greece. LT sO/W defence
  • sO/W Banks
  • Neutral+ EU High-yield
  • Neutral GBP & Gilts
  • sO/W UK breakeven
  • sU/W UK FTSE 250
  • sO/W Ireland

  • sO/W Gold as a possible hedge

Key: U/W = underweight, O/W = overweight, s= soft, ST = short-term, LT = long-term

Source: Lyxor CAR, July 2017

Disclaimers

All data sourced by: Lyxor & SG Cross Asset Research teams, July 2017. Opinions expressed are as at July 2017. 

This communication is for professional clients only.

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