Fed signals higher rates

Transcription

1 DM equities EM equities UST (7-10 yrs) Global Agg Global EM Global HY WTI Crude Oil Gold 1 Jun 2016 Fed signals higher rates Key takeaways We continue to favour risk assets such as global equities, corporate bonds and high-yield debt relative to developed market (DM) government bonds Global equities edged higher in May, with risk appetite supported by generally upbeat global economic data releases as well as further gains in oil prices The release of the Federal Reserve (Fed) April meeting minutes surprised investors by making several references to the possibility of a rate increase as early as June In the Eurozone, we still expect the European Central Bank (ECB) will remain under pressure to ease policy further given that headline inflation remains close to zero Chinese economic data remains consistent with a broad stabilisation in conditions, supported by recent policy measures, such as increased infrastructure spending Fed puts summer rate hike firmly on the table A volatile start to 2016 for global financial markets saw the market-implied odds of an US rate hike this year plummet. However, these odds dramatically increased in May on the back of continuing evidence of the resilience of the US economy (and further signs of inflationary pressures) as well as a stabilisation in global financial conditions, with the Fed s willingness to act confirmed by both hawkish Fedspeak and April meeting minutes. Encouragingly, risk assets were little affected over in May, signalling that investors remain confident (for now) that the global economy is resilient enough to withstand slightly tighter US monetary policy and a steeper hiking path ahead. This reaffirms our preference for risky assets such as global equities, emerging market (EM) debt as well as high-yield credit. Nevertheless, risks to the outlook abound, namely in the shape of the impact of Chinese rebalancing on the global economy, whilst political risk in Europe remains elevated. Asset class performance: May 2016 % Equities Bonds Commodities MTD YTD Chart of the month: Financial market expectations of Fed action in June jumped higher in May % Dec 15 Jan 16 Feb 16 Mar 16 Apr 16 May 16 % Note: UST= US Treasury; Agg= Aggregate; HY= High Yield; WTI= West Texas Intermediate; DM= Developed Market; EM= Emerging Market. Equity returns are expressed in local currency. Bond and commodity returns are expressed in USD. Source: Bloomberg, data as at 31 May For illustrative purposes only and does not constitute any investment recommendation in the above-mentioned asset classes. Past performance is not indicative of future performance. Futures implied Fed Funds interest rate in December 2016, RHS % chance that the Fed will hike interest rates on 15 June 2016, LHS Source: Bloomberg, data as at 1 June For illustrative purposes only and does not constitute any investment recommendation in the above mentioned indices. Any forecast, projection or target contained in this presentation is for information purposes only and is not guaranteed in any way. HSBC accepts no liability for any failure to meet such forecasts, projections or targets. This commentary has been produced by HSBC Global Asset Management to provide a high level overview of the recent economic and financial market environment, and is for information purposes only. The views expressed were held at the time of preparation; are subject to change without notice and may not reflect the views expressed in other HSBC Group communications or strategies. This marketing communication does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as investment research. The content has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. You should be aware that the value of any investment can go down as well as up and investors may not get back the amount originally invested. Furthermore, any investments in emerging markets are by their nature higher risk and potentially more volatile than those inherent in established markets. Any performance information shown refers to the past and should not be seen as an indication of future returns. You should always consider seeking professional advice when thinking about undertaking any form of investment.

2 Long term Asset class positioning (>12 months) Asset class View Rationale Equities Global Neutral Positive factors: We expect to be better rewarded over the long term for holding global equities rather than developed market (DM) cash or government bonds. We continue to believe that the global economic recovery is on track, and global equity markets will post positive returns over the long term, with equity market weakness at the beginning of 2016 reflecting an over-priced probability of recession. Overall, support from the continuation of incredibly accommodative monetary policy will, in the medium and longer term, likely outweigh headwinds created by more modest Chinese growth, gradual tightening in US monetary policy and political uncertainty in many regions. Risks to consider: Looking ahead, concerns surrounding Chinese growth, the uncertainty of the tightening path ahead for US monetary policy and the implications of weaker commodity prices may continue to flare up leading to episodic volatility such as in mid-2015 and early Overall, we remain neutral for this asset class given that valuations are less attractive now than they were a year or two ago. A notable and persistent decline in the global economic outlook could dampen this view. US Underweight Rationale of underweight views: Recent profit momentum has slowed amid a stronger US dollar (versus 2014 H1) and energy price weakness, whilst US wage inflation has begun to rise. Meanwhile, an elevated corporate profit share suggests little room for further growth. Valuations are also relatively high with the implied risk premia lower than in other developed markets. Rising inflation without an associated pickup in economic growth implies a less constructive Fed hiking cycle than one driven both by inflation and growth. Positive factors to consider: A durable US economic recovery and a growth-focused central bank remain supportive for US equities. Meanwhile, low energy prices and a strengthening labour market boost the potential for a pickup in consumption growth. UK Neutral Positive factors: The volatility in GBP year to date (linked to domestic political uncertainty and the shifting interest rate outlook) has been significant and may ultimately support UK equities going forward considering their relatively high dependence on foreign earnings. Furthermore, signs of a stabilisation in commodity prices should also be supportive given the UK market s heavy exposure to the natural resources sector. Finally, UK growth remains strong, and is expected to outperform other G7 economies this year. Risks to consider: The upcoming European Union (EU) membership referendum on 23 June maintains a significant level of uncertainty, which coupled with potential interest rate increases in 2017, will likely maintain volatility at an elevated level in the medium term. Similar to the US, there are nascent signs of wage inflation which could eat into profit momentum. Eurozone Overweight Rationale of overweight views: We favour Eurozone equities because of their higher implied risk premia and the scope for better news in profits given its earlier stage in the recovery phase. Furthermore, the monetary backdrop remains supportive as confirmed by March s aggressive European Central Bank (ECB) stimulus package, with the potential for further easing if inflation remains anaemic and the ongoing economic recovery slows. Risks to consider: Concerns over the health of the European banking sector amid lingering political risks in the periphery could weigh on Eurozone equities this year while, if inflation rises faster than expectations, monetary easing could be less accommodative than anticipated. The region is also vulnerable to external headwinds, particularly the slowdown in global trade and softness in emerging markets. Finally, similar to the Japanese yen, the euro has strengthened this year, despite aggressive monetary policy easing. Japan Neutral Positive factors: In the near-to-medium term, Japanese earnings per share may rise, supported by the Bank of Japan s extremely loose monetary policy which could see the yen depreciate further, boosting the value of overseas earnings. Secondly there is increasingly limited room for additional Japanese Government Bond (JGB) buying and a comparatively narrow corporate credit market. Therefore the Bank of Japan (BoJ) could opt to increase its equity holdings providing a further stimulus boost. Relative valuations and risk premia are also attractive, whilst Japanese stocks have limited exposure to the commodities sector. Japanese corporates also have large cash piles, so there is plenty of scope for cash to be returned to shareholders via dividends, or for greater stock repurchases. Risks to consider: Europe and Japan have similar expected returns but the required return for Japan is greater in our view, due to the larger uncertainty surrounding the earnings outlook. Earnings momentum has slowed somewhat amid external headwinds and poor domestic fundamentals. An additional source of uncertainty is that despite the Bank of Japan s recent adoption of Negative Interest Rate Policy (NIRP) in late January, the yen has since strengthened - a key risk for export-sensitive Japanese stocks. Finally, further BoJ interest rate cuts could be constrained by recent concerns surrounding the impact of negative interest rates on financial sector profits, whilst equity purchases raise uncertainties related to the bank becoming a major shareholder in the Japanese stock market. Overall, we continue to hold this position with a positive bias, rather than a full overweight position. Global Emerging Markets (GEM) Overweight Rationale of overweight views: Emerging Market (EM) equities are attractive for western-based currencies (USD, GBP or EUR based) given our expectation of longer-term currency appreciation. However, we continue to be selective in EM equity valuations, especially as sovereign returns remain high. Within EM, Asia is our preferred region, as the prospective returns 01/06/2016 Investment Monthly 2

3 Central and Eastern Europe (CEE) & Latin America (LatAm) Government bonds Corporate bonds Global investment grade (IG) - USD investment grade - EUR and GBP investment grade Neutral Neutral Neutral Neutral look higher, sustained by a continued supportive economic environment. Risks to consider: There could be some near-term volatility as worries remain around the uncertain path for future Fed tightening, the rate of economic adjustment in China and the robustness of the global economy as a whole. Meanwhile, further weakness in commodity prices pose risks for major commodity exporters. Positive factors: Longer term, we anticipate positive growth differentials with Developed Markets to be maintained. Certain Central European markets continue to look interesting on a tactical basis, e.g. Poland and Hungary. However, we remain tactically neutral for these markets overall. Risks to consider: Shorter term, these markets are vulnerable to concerns about reduced global liquidity, while commodity prices may continue to be a severe impediment for commoditydependent producers. Geopolitical tensions are also high and unpredictable, whilst domestic political and macro fundamentals remain poor in many countries, such as Brazil. Global Underweight Rationale of underweight views: At an aggregate level, global government bond yields (of which the majority are core developed market) are still too low in our view. Our expectations for long-term returns from this asset class are therefore still low. This is true even after we embed the Fed s more dovish rate scenario. Positive factors to consider: Government bonds still play an important role to provide diversification benefits and reduce volatility within multi-asset portfolios. Furthermore, Treasury Inflation Protected Securities (TIPS) look relatively attractive, although absolute returns less so. A further adoption of negative interest rate policy by a wider number of central banks or a renewal of deflationary pressures may provide further price support. US Underweight Rationale of underweight views: We believe US treasuries are currently pricing in an overly pessimistic outlook for the US economy. With yields still low (and real yields even lower), we prefer to be underweight and instead maintain a preference for risk assets such as equities, highyield credit and EM debt. Positive factors to consider: If US growth disappoints or the recent rise in inflation stalls, monetary policy may become more accommodative and prove supportive for this asset class in the short-term. Government bonds continue to offer a diversification element, important in a volatile environment. UK Underweight Rationale of underweight views: We believe UK gilt yields are also too low relative to their long-term averages and are pricing in an overly pessimistic macroeconomic outlook. Hence, on a relative basis we generally prefer risk assets to perceived safe-haven government bonds. Positive factors to consider: Rising uncertainty over the UK s membership of the EU may also weigh on growth, allowing monetary policy to stay accommodative for longer. Eurozone Underweight Rationale of underweight views: Similarly, core European bonds are overvalued in our view, but with European QE continuing and likely to be extended this may not correct soon. Yields are still extremely low with overall price upside likely to be limited at best. Positive factors to consider: The recent aggressive expansion of the ECB s Asset Purchase Programme (APP) may provide further near-term support to this asset class, with the potential for further expansion of this programme possible if inflation fails to rise. Emerging markets Overweight Rationale of overweight views: The yield pick-up on USD-denominated EM sovereign debt makes them attractive relative to DM government debt in our view. Meanwhile, our estimate of the sustainable return on EM local currency bonds remains attractive. Risks to consider: Spreads in the EM debt universe are at risk of widening as US policy tightens. Bonds from commodity-dependent currencies and with significant external financing needs are particularly at risk. Local-currency bonds have lost ground with a stronger USD recently, although we expect stronger local currencies longer term. Positive factors: Corporate balance sheets remain in good shape and default rates are low. Furthermore, spreads continue to look attractive on a relative basis versus what is available to multi-asset investors in other asset classes. Risks to consider: We retain a neutral positioning for this asset class, particularly as tighter US monetary policy remains a risk given exceptionally low market expectations. Positive factors: There is a wide spread between USD and EUR-denominated investment grade corporate bonds. The US may outperform given conservative selection. Risks to consider: Improved relative valuations for USD-denominated credit is offset in the nearer term by the risk of a more aggressive pace of Fed tightening. The US credit cycle is more mature than that in Europe which remains nascent. Furthermore, the profit share of GDP has been on a declining trend over the past year, bank lending standards have continued to tighten in Q1, and leverage ratios are rising. Positive factors: Euro-denominated investment grade corporate bonds continue to be supported by QE, with the latest ECB package expanding the pool of eligible securities for purchase to include investment grade rated non-bank corporate bonds from the end of Q Meanwhile, while the latest survey data suggests a gradual improvement in credit conditions and default rates remain low. However, valuations are still around neutral levels. Risks to consider: The potential for a worsening economic environment should global growth surprise to the downside. Global high-yield Overweight Rationale of overweight views: The widening of developed market high-yield credit spreads since mid-2014 has improved valuations and with it, our estimate of the expected return for this asset class. Defaults remain comparatively low and yields attractive. Risks to consider: As with IG, as the market starts to anticipate tighter US monetary policy, highyield credit could be volatile in the short term. Another challenge remains the news-flow around 01/06/2016 Investment Monthly 3

4 defaults and whether this spreads beyond energy and commodity-focused names. Gold Neutral Positive factors: The likelihood of further significant USD appreciation, a negative for gold, seems limited as Fed hikes are likely to remain very gradual. Meanwhile, the increasing adoption of negative interest rate policy (NIRP) on deposits among global central banks reduces the opportunity cost of holding the yellow metal. Fear of further depreciation of the Chinese yuan could support gold whilst any significant deterioration in the US economy could force the Fed to pause its hiking cycle providing further support. Risks to consider: Subdued inflation expectations mean demand as an inflation-hedge is likely to be limited, especially as oil prices remain weak. Any further oil price falls could exacerbate this. A stronger-than-expected Fed hiking cycle may push the USD higher. Other commodities Neutral Positive factors: Crude oil prices remain below our estimate of long-term fair value and with oil demand growth remaining robust there is scope for the market to rebalance this year, as non- Organization of the Petroleum Exporting Countries (OPEC) supply declines moderately, especially US shale. Risks to consider: For oil, the market could remain oversupplied if expected cuts to US shale output fail to materialise and/or OPEC significantly lifts output this year, led by a post-sanctions Iran. Industrial metals remain exposed to the pace of China s economic rebalancing and global economic growth. Real estate Neutral Positive factors: Based on our outlook for future rental values in key developed markets and current dividend yields, we believe listed property equities offer reasonably attractive long-run prospective returns relative to core Developed Market government bonds. After years of Quantitative Easing (QE), which have led to falling property yields in many markets, rental value growth (rather than yield compression) is expected to become the main driver of future net asset value growth. Risks to consider: Increases in interest rates could negatively impact listed real estate returns in the short term. Development risks have increased in some markets. The uncertainty relating to a potential 'Brexit' continues to pose downside risks for UK real estate. Asian assets EM Asian Fixed Income Underweight Rationale of underweight views: From a near-term perspective, this asset class is sensitive to US monetary policy. Whilst a more gradual interest rate hike cycle in the US is positive for the asset class, Asian bond spreads look tighter (225bp for the EMBI Global Asia as at 31 May) than in other regions of the EM space (553bp for the EMBI Global Latin America for example), which reduces their relative attractiveness in the near to medium term. Positive factors to consider: From a long-term perspective, return signals are still positive, backed by relatively sound economic fundamentals, stable inflation and credit quality. Asia ex Japan Equity Overweight Rationale of overweight views: Overall supportive domestic macro policies, the prospect of gradual Fed normalisation amid an improving US economy, near-term growth stabilisation in China, reduced short-term FX/RMB risks, as well as a focus on corporate balance-sheet optimisation should be positive for Asia ex. Japan equities. There are early signs of earnings stabilisation and margins are rising. Structural reforms in many parts of the region could provide a re-rating potential. Risks to consider: Given the low growth environment, there are few signs of an inflection point for the trend in return-on-equity or catalysts to drive a meaningful earnings rebound in the near term. There is the potential for capital outflows and currency volatility given uncertainties over the trajectory of US interest rates and the global/chinese economic outlook. Sluggish global trade and high leverage are also headwinds. Asian equity markets will therefore likely remain volatile in the near term. - China Overweight Rationale of overweight views: Near-term growth stabilisation amid overall accommodative macro policies could support the market. A combination of policy initiatives in various sectors (e.g. the 13th Five-Year Plan), the emergence of new sectors, and earnings recovery in some sectors provide opportunities in related areas. Excess capacity reduction and State-Owned Enterprise (SOE) restructuring will be positive for long-term growth prospects, despite short-term pains. Any progress on policy priorities such as the Shenzhen-HK Stock Connect or MSCI inclusion could be positive. Economic rebalancing, capital market liberalisation and structural reforms are medium-term catalysts. Risks to consider: Chinese stocks will likely continue to face headwinds to economic growth and corporate earnings (e.g. industrial overcapacity, elevated corporate leverage, diminishing return on capital, etc.), as well as RMB and Fed policy uncertainty. Market volatility will likely stay high in the near term. The government s pro-growth strategy could slow or delay crucial SOE/structural reforms and come at the cost of a further rise in corporate and government debt levels. Corporate default risks and deterioration in bank asset quality are concerns. The risk of policy missteps is high. - India Overweight Rationale of overweight views: Progress has been made on reforms, especially in areas such as Foreign Direct Investment (FDI) and the mining, power and road infrastructure sectors. The new bankruptcy law marks one major financial sector reform aimed at cleaning up banks balance sheets. Monetary policy will remain accommodative, and policy transmission is expected to improve, with the Reserve Bank of India (RBI) improving liquidity management and banks starting to reduce lending rates. Fiscal discipline is good for macro stability. The expectation for a normal monsoon bodes well for rural demand. Green shoots are emerging in earnings prospects amid an ongoing economic recovery. Risks to consider: Optimistic earnings expectations and weak Return On Equity (ROE) trajectory, relatively high valuations (but the premium to other Asian stocks declined), stressed assets in the banking system, as well as uncertainties over the fate of key reform legislations (e.g. the GST bill) and the outlook for the Fed policy, USD and oil are concerns. The credit cycle and private capex remain weak. - Hong Kong Neutral Positive factors: There are sectors/stocks benefiting from DM recovery with global diversification. Near-term stabilisation in mainland Chinese growth/rmb expectations could help. Expansionary 01/06/2016 Investment Monthly 4

5 fiscal policy could support domestic growth. In the longer term, integration with China, including the One Belt One Road initiative, could help raise productivity of Hong Kong s service economy. Risks to consider: A combination of sluggish external demand and a weak domestic retail sector/ inbound tourism has weighed on the Hong Kong market. Hong Kong asset markets and economy face risks from tightening of monetary conditions (due to rising US interest rates and/or capital outflows), a structural deceleration in the Chinese economy, and subdued domestic growth outlook. Credit risk from trade financing (mainly exposure to mainland China) needs to be monitored. - Singapore Underweight Rationale of underweight views: The country s transition from a labour-driven economic model to a productivity-driven one remains challenging and incurs short-term pain on Gross Domestic Product (GDP)/ earnings/ employment growth. Singapore faces the risk from rising US interest rates/usd strength. Weak external demand, a shifting manufacturing landscape, unwinding of the leverage cycle/tighter financial conditions, and a slowing property market are headwinds. Positive factors to consider: The Singapore market lists some of the most high-quality, low beta and defensive companies. The dividend yield is one the highest in the region and valuations are supportive. MAS calibrated easing and a modestly expansionary fiscal policy, especially some measures to support businesses, could offer some cushion against downside growth risks. - South Korea Overweight Rationale of overweight views: Shareholder-return friendly policy (e.g. dividend payouts and share buy-backs) and group restructuring support Korean equities. A gradual recovery in domestic demand and the housing market amid pro-growth policy help earnings prospects (we have recently seen positive earnings momentum). Corporate restructuring could incur some short-term economic pains, but will help reduce financial stress and enhance longer-term competitiveness and growth potential of the economy. Risks to consider: The uncertain global and Chinese economic outlook, global trade stagnation, debt overhang and overcapacity domestically, and rising tension related to North Korea remain key concerns. Currency is a swing factor for exports and earnings (recent won weakness is a positive). - Taiwan Neutral Positive factors: Monetary and fiscal policies are accommodative. The new government is likely to focus on domestic reforms e.g. industrial upgrading, tax, pension, healthcare and the financial sector as well as trade negotiations and inbound investment. We see opportunities in some tech companies in the niche market and/or with optimal balance sheets and capital structure. Taiwan is also positively geared to a relatively positive US growth story. The high dividend yield is a positive. Risks to consider: Weak global demand/trade outlook, China s economic transformation, and sluggish domestic demand remain headwinds. The technology sector is facing challenges from a slower growth trajectory with end demand remaining subdued and increasing competition (from China). FX movements remain important for tech company earnings. There is the concern about deterioration in cross-strait relations as China increases political pressure on Taiwan s new leader. Basis of Views and Definitions of Long term Asset class positioning table Views are based on regional HSBC Global Asset Management Asset Allocation meetings held throughout May 2016, HSBC Global Asset Management s long-term expected return forecasts which were generated as at 29 April 2016, our portfolio optimisation process and actual portfolio positions. Underweight, overweight and neutral classifications are the high-level asset allocations tilts applied in diversified, typically multi-asset portfolios, which reflect a combination of our long-term valuation signals, our shorter-term cyclical views and actual positioning in portfolios. The views are expressed with reference to global portfolios. However, individual portfolio positions may vary according to mandate, benchmark, risk profile and the availability and riskiness of individual asset classes in different regions. Overweight implies that, within the context of a well-diversified typically multi-asset portfolio, and relative to relevant internal or external benchmarks, HSBC Global Asset Management has (or would have) a positive tilt towards the asset class. Underweight implies that, within the context of a well-diversified typically multi-asset portfolio, and relative to relevant internal or external benchmarks, HSBC Global Asset Management has (or would have) have a negative tilt towards the asset class. Neutral implies that, within the context of a well-diversified typically multi-asset portfolio, and relative to relevant internal or external benchmarks HSBC Global Asset Management has (or would have) neither a particularly negative or positive tilt towards the asset class. For global investment grade corporate bonds, the underweight, overweight and neutral categories for the asset class at the aggregate level are also based on high-level asset allocation considerations applied in diversified, typically multi-asset portfolios. However, USD, EUR and GBP investment grade corporate bonds are determined relative to the global investment grade corporate bond universe. For Asia ex Japan equities, the underweight, overweight and neutral categories for the region at the aggregate level are also based on high-level asset allocation considerations applied in diversified, typically multi-asset portfolios. However, individual country views are determined relative to the Asia ex Japan equities universe as of 31 May Similarly, for EM government bonds, the underweight, overweight and neutral categories for the asset class at the aggregate level are also based on high-level asset allocation considerations applied in diversified, typically multi-asset portfolios. However, EM Asian Fixed income views are determined relative to the EM government bonds (hard currency) universe as of 31 May /06/2016 Investment Monthly 5

6 Fed signals higher rates Global equities edged up in May, supported by upbeat global economic data as well as further gains in oil prices Global equities edged higher in May, with risk appetite supported by generally upbeat global economic data releases as well as further gains in oil prices. The MSCI AC World index finished 1.2% higher in May (in local currency terms). In the US, the S&P 500 index rose 1.5% on the back of rising optimism that the US economy would be able to withstand further rate hikes amid growing expectations of Fed action this summer. Elsewhere, the MSCI Japan also rose (+2.6%), on a weaker yen and increasing hopes of a delay to the government s planned consumption tax hike scheduled for April 2017 along with the possibility of a fiscal stimulus package to help boost economic growth. Meanwhile, European stocks performed well again in May, with the MSCI Europe up 1.5%, with exporter shares boosted by a weaker euro against the US dollar. Risk appetite was also buoyed by progress on talks towards securing a debt relief deal for Greece and comments from ECB supervisory chief Nouy who said the bank was working on new proposals for non-performing loans in the region, an issue that has been especially plaguing Italy. Emerging market (EM) stocks underperformed their developed world counterparts again in May, with the MSCI EM index declining (- 1.0%), on expectations that higher US interest rates could potentially trigger capital outflows. In particular, the MSCI Brazil fell sharply (-10.1%), reversing some of the strong gains made this year so far, as investors assessed the country s economic prospects following a change of government amid a raft of disappointing Q1 earnings results. In China, the Shanghai Composite fell (-0.7%), pressured by weaker industrial metals prices (hitting resource stocks), although support came at the end of May on growing investor optimism over the inclusion of A- shares in MSCI benchmarks. Oil prices extended recent gains in May, at one point breaching the psychologically significant USD50 level for the first time since November This latest rally came on the back of a weaker US dollar, temporary supply disruptions (Nigeria, Libya, Canada), and a continued decline in US crude production amid a significant fall in inventories. In terms of government bond markets, shorter-dated US treasuries declined in May, with policy-sensitive 2-year yields edging up 10bp to 0.88% on stronger rate hike expectations this year. Conversely in Europe, government bonds gained amid the ECB s EUR80bn a month asset purchase programme. Furthermore, data showing April year-on-year (yoy) inflation in negative territory supported expectations of further ECB easing this year (all data above as of 31 May 2016 in local currency, price return). May s US economic data provides encouraging signs that Q1 s weakness is like to have been temporary Data released out of the in May continues to indicate a resilient macroeconomic backdrop. Although April s employment report showed non-farm payroll growth coming in at a disappointing 160,000, the weakest since September 2015, wage growth was firmer at 2.5% yoy and hours worked rose to 34.5, both supportive for total income. Importantly, shortly after the report, Fed Vice Chair Dudley stated that he wouldn t place too much emphasis on the slightly softer headline number given the underlying strength in the details. Meanwhile, there were two key positive releases in May reflecting a stronger start to Q2 for the US consumer. April core retail sales saw their strongest monthly rise since March 2014 (+0.9% mom), whilst consumer sentiment in May, as measured by the University of Michigan, remained at elevated levels (Figure 1). More broadly, the continuing strength in the service sector is reflected in the April ISM Non-Manufacturing Composite Index, which rose more than expected to 55.7 from 54.5 in March, remaining well-above the 50 no-change level. Also, while the manufacturing PMI was somewhat weaker than expected, it remained expansionary, with the strength maintained in new orders (55.8) particularly encouraging. Figure 1: After a disappointing 2015, the US consumer is starting to show signs of life amid elevated confidence levels % yoy, 3M 3MMA MA Core Retail Sales (LHS) University of Michigan Consumer Sentiment Index (RHS) Note: 3MMA= 3 Month Moving Average. Index 100 Source: Bloomberg, as at 1 June For illustrative purposes only and does not constitute any investment recommendation. The second release Q1 US GDP was revised up to 0.8% quarteron-quarter (qoq) annualised from 0.5%, reflecting slightly less of an inventory drawdown and a smaller drag from net exports. The weakness coming from lower equipment spending, primarily as a result of the struggling oil and gas sector, was maintained. However, we anticipate this will lessen going forward on the back of the recent recovery in oil prices, with little room for spending to fall further. The Fed s readiness to act is much greater than previously thought, but gradual remains the watch word The release of the Fed s April meeting minutes in May surprised investors by making several references to the possibility of a rate increase as early as June - subject to continued improvement in economic conditions, particularly consumer spending. We expect this surprise came due to the fairly wide range of views on the committee, which meant a specific reference to the potential for action in June was excluded from the April statement. Given this explicit reference, coupled with the Fed s evident concern that the /06/2016 Investment Monthly 6

7 Fed signals higher rates market is underestimating the trajectory of interest rate increases, we saw the market-implied probability of a 25bp rate hike in June jump from 4% to 32% after the release of the minutes. Later in May, Fed chairwoman Yellen did little to curb expectations of a summer rate hike rate by telling an audience in Boston that such a move would probably be appropriate in coming months. Our views from April remain unchanged: assuming growth picks up in Q2 and onwards, with no significant deterioration in global and economic financial conditions, we expect the Fed to raise rates once in the coming months and once again before the end of year. The Eurozone recovery continues to be supported by domestic demand, although inflation remains anaemic Data released out of the Eurozone during May remains broadly upbeat. The second estimate of Eurozone Q1 GDP was revised down slightly to 0.5% qoq, although remains the strongest outturn since Q (Figure 2). The details of the components at the aggregate Eurozone level will be released on 7 June, although we expect that domestic demand was the key driver of growth, whilst net trade likely remained a drag. The breakdown available for Germany and France confirms this story, with the former outperforming at 0.7% qoq. Italy remains the laggard of the Big Four, with growth of only 0.3% qoq, hobbled by lingering structural weaknesses and low productivity growth. Meanwhile the latest Eurozone industrial production print for March disappointed, coming in at -0.8% mom (+0.2% yoy). However, we expect this reflects some pullback from January s exceptionally strong expansion in Germany, with the 3-month moving average rate of yoy Industrial Production (IP) growth at a robust 1.6%. Looking ahead, we expect industry to remain on a solid footing this year and are particularly encouraged by the recent pick-up in German factory orders and manufacturing Purchasing Managers Index (PMIs). Nevertheless, headwinds from a stronger euro and softness in key emerging markets makes us doubt the pace of Q1 IP growth can be maintained and expect this to contribute to a slight moderation in Eurozone GDP growth in the coming quarters. In terms of monetary policy, we still expect the ECB will remain under pressure to ease policy further given that headline inflation remains close to zero (Figure 2). Figure 2: The Eurozone recovery remains broadly intact, although inflation remains well below the ECB s 2% target % qoq % yoy Eurozone GDP, LHS Eurozone CPI Inflation quarterly average, RHS Source: Bloomberg, as at 1 June For illustrative purposes only and does not constitute any investment recommendation And although the base effects of energy prices are likely to wear off in the second half of the year, we expect inflation will remain substantially below the ECB s 2% target well into Our base case scenario is that the existing EUR80bn a month Asset Purchase Programme, which expires in March 2017, is extended by six months, and there is also the possibility of the amount of purchases being increased. However this option is likely to face resistance from Germany. Meanwhile the scope for further deposit rate cuts will be limited by concerns over the impact of profitability in the banking sector. Chinese economic data remains consistent with a broad stabilisation in conditions Following a notable pickup in Chinese economic activity in March, data released for April showed a slight softening in growth momentum, with industrial production falling back to 6.0% yoy (Figure 3). However, some payback was expected given that the March data reflected distortions from the Chinese New Year holidays, inventory re-stocking, rebounding commodity prices as well as rapid credit expansion at the beginning of the year. Figure 3: Chinese economic data softened in April, but remains consistent with an overall stabilisation in conditions % yoy Jan 14 May 14 Sep 14 Jan 15 May 15 Sep 15 Jan 16 Fixed Asset Investment (LHS) Industrial Production (RHS) Retail Sales (LHS) % yoy Source: Bloomberg, as at 1 June For illustrative purposes only and does not constitute any investment recommendation. We believe that Chinese growth in the near-term should continue to find support from recent policy measures, such as increased government spending on infrastructure. Meanwhile, the property sector remains buoyed by accommodative monetary policy (although high inventories remain a drag in tier-three cities). However, there is a significant degree of uncertainty about the longer-term sustainability of the recent credit fuelled investment rebound, particularly given the declining marginal effect of policy stimulus amid growing concerns over the financial risks of excessive credit creation. Therefore, we believe the government could scale back policy easing in H2 provided that it feels confident it will achieve its 2016 growth target (of %). Nevertheless, given that economic rebalancing and structural reforms remain a significant government policy objective (including the reduction of industrial overcapacity) ad-hoc policy adjustments may be inevitable in order to maintain a steady growth rate /06/2016 Investment Monthly 7

8 Fed signals higher rates The Japanese economy remains weak, with better-thanexpected Q1 GDP data distorted by leap year effects In Japan, the first estimate of Q1 GDP surprised to the upside, growing 1.7% qoq annualised, beating expectations of +0.3% qoq, and picking up from the downwardly revised 1.7% qoq contraction (previously -1.1% qoq) in Q However, it is important to note that leap year effects - a factor not adjusted for in Japan's GDP statistics boosted the headline number. Therefore, we expect quarterly GDP growth to print closer to zero for Q2 amid headwinds of a stronger yen this year, sluggish external demand, weak business investment and subdued consumer spending. Meanwhile, the inflation picture remains anaemic, with CPI exfresh food and energy coming in at 0.9% yoy in April, its lowest level since July Therefore, at its 16 June meeting, the Bank of Japan (BoJ) may choose to ease policy further by extending the pool of assets eligible under its QE programme, for example into corporate bonds or Exchange Traded Funds (ETFs). However, whilst still a possibility, further rate cuts will be considered as a last resort measure given their potential negative side effects, for example by squeezing banks net interest margins and inducing higher saving rates to offset the impact of negative yields. The government also decided to delay the next consumption tax hike scheduled for April 2017 until October The opportunity of a supplementary budget has also been discussed over the past few months, but its justification could now be diminished with the delay going ahead. Emerging market assets came under pressure in May, although underlying fundamentals remain idiosyncratic May s relatively hawkish guidance from the Fed, talking up a possible rate hike this summer, contributed to selling pressure on emerging market (EM) assets in May (Figure 4). However, the falls have been somewhat limited as investor sentiment was buoyed by resilient oil prices, breaking through USD50 for the first time in seven months, supporting the outlook for a number of EM commodity-producing countries. Figure 4: EM equities gave back some of their gains from 2016 during May amid higher expectations of Fed tightening 1st Jan 2016 = FX appreciation, equities higher FX depreciation, equities low er Jan 16 Feb 16 Mar 16 Apr 16 May 16 Jun 16 MSCI EM Equities (Local) JP Morgan EM FX Index Source: Bloomberg, as at 1 June For illustrative purposes only and does not constitute any investment recommendation. At the country level, Brazil s enduring political crisis culminated in May with the decision by the country s senate to impeach President Dilma Rousseff, temporarily making way for marketfriendly opposition leader, Michel Temer. Several ministerial posts have also been appointed, including new central bank governor Goldfajn who recently expressed that slowing inflation could clear the way for monetary easing, probably starting in July. Despite Latin America largest economy taking important first steps to escape its worst recession in history, economic growth is only expected to return in Q Similarly, Turkey continues to be hamstrung by an uncertain domestic political climate, reflected in the unexpected resignation of Prime Minister Davutoglu on 3 May. This volatile backdrop has dampened investor confidence in the country and reduced the likelihood of economic reforms being implemented, amid other headwinds such as weak foreign demand and investment amid geopolitical risks in the region. Nevertheless, growth should find support from low oil prices and consumption boosting policies (e.g. this year s minimum wage hike). Meanwhile, falling headline inflation has allowed the central bank to cut the overnight lending rate by 125bp this year. Meanwhile, Mexico remains one of the bright spots in the EM universe, with final Q1 GDP revised upwards to 0.8% qoq (0.7% previously) amid strong consumer spending growth (March s retail sales came in 3.0% mom vs consensus 0.1%), supported by a robust labour market and strong remittances from the US. The central bank kept its policy unchanged in May, but the extent to which the policy path should follow that of the Fed was hotly discussed. In India, recent activity data continues to show an ongoing cyclical recovery, led by urban consumption and public investment. However, the pace remains modest and uneven with rural demand and private capex remaining weak. The expectation for a good monsoon this year bodes well for an increase in agricultural output and higher rural incomes. This combined with coming pay hikes, a supportive monetary and fiscal policy and the potential positive impact of recent reforms should continue to underpin the economic recovery. In May, a very positive development was a new bankruptcy law, making it easier to wind up a failing business and recover debts. Not only should this help improve banks balance sheets, but also ease of doing business in India more generally. More generally speaking, deteriorating global trade and subdued commodity prices continue to pose significant headwinds for EM economies. Furthermore, tighter financial conditions on the back of potentially higher policy rates in the US could also weigh on the outlook, especially for economies marred by elevated levels of US dollar denominated debt. EM real GDP growth is forecasted to expand by 4.3% in 2016, below the post-crisis ( ) average of 5.6%. 01/06/2016 Investment Monthly 8

9 Fed signals higher rates We maintain our preference for risky assets, although they are slightly less attractive following the recent recovery The tactical justification for an allocation into risky assets has been reduced following their recovery since February s lows. Nevertheless, in a benign macro environment (with positive, yet lacklustre growth at the global level), the carry associated with riskier asset classes still looks reasonable. Therefore we continue to favour such risky assets within the context of a well-diversified multi-asset portfolio, from a strategic and long-term perspective. For equities, the profits picture remains the key risk factor, particularly in the US (hence our underweight positioning in US equities). However, the valuation case for equities remains strong, especially compared to government bonds, which continue to price a very pessimistic scenario for growth (especially against a backdrop of rising underlying inflation in the US). We also prefer EM debt, which still offers an attractive risk/reward, despite strong recent outperformance. Finally, within credit markets, we maintain our preference for US High Yield, where although fundamentals are gradually deteriorating, there are still good opportunities for further spread compression over the medium term. 01/06/2016 Investment Monthly 9

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