Key takeaways October 2017

Transcription

1 Document intended for professional clients Document intended for professional clients Key takeaways October 2017 Strong, synchronized and ongoing non-inflationary world growth (4%). Central banks are still concerned over sluggish inflation, yet are planning to implement significant monetary tightening in 2018 for the Fed it s a case of financial stability, while technical reasons are motivating the Bank of Japan (shortage of JGBs), political reasons are behind ECB moves (issue share limits), and external factors explain the Bank of England s actions (current account deficit, household debt). Risky asset valuations are incompatible (equities, credit, real estate) with the steepening on the yield curve in G4 countries implied by the scenario of seamless monetary normalization. Yet these valuation levels have become vital in ensuring continued strong world growth via wealth effects. Either the yield curves bear-steepen and asset prices and world growth take a severe dip, or yield curves continue to flatten maintaining the current pace of strong growth and inflation in the asset prices, but marking a clear sign of mistrust of normalization scenarios from central banks will see a choice between ongoing world growth and credibility for central banks. Twofold rise in cost of capital for countries with dollar debt (Turkey, Argentina, etc.) or that are subject to capital outflow risk (China), with the hike in the Fed funds rate and the rise in the premium on dollar funding (cross-currency basis swaps). Canada and Australia, which depend on dollar-denominated inflows to maintain their real estate bubbles, are also vulnerable. Maintaining an offensive stance in our portfolios but cutting back risk on our equity overweight position: o Neutralization of our emerging Asia long position o Neutralization of our US short position o Shift of part of euro area long equity positions to European high yield debt o Bolstering our currency hedges in the dollar Raphaël Gallardo Multi-asset strategist Investment and Client Solutions Tactical views GLOBAL -- - = + ++ Equities Fixed income Money Market EQUITIES -- - = + ++ US Europe Japan Asia ex Jap EM FIXED INCOME Sovereign Euro IG -- - = + ++ Euro HY EM Debt : monthly views : views of the previous month

2 Editorial: the triumph of Abenomics Japan posted growth of 1.5% in the first half of the year, which is a remarkable performance for an economy with estimated potential of no more than 1%. Expansion in the Japanese economy is propelled by all drivers of private demand: exports, productive investment, household spending. The strength of this phase of growth is due to the fact that it is not driven by the improvement in world trade alone, as was the case for all the Japanese economy s false starts over the past two decades, but rather it is the result of synergies uniting the three arrows of Prime Minster Shinzo Abe s economic program (fiscal stimulus, monetary easing, structural reforms). Monetary policy is based on three areas (QE, negative policy rates and control on the yield curve) to keep the yen weak and long-term rates low despite a continued unsustainable budget deficit (public debt was monetized at 45%). Reforms to the labor market promote immigration and increase the presence of women in the workforce, thereby ensuring that Japanese companies maintain wide margins despite achieving full employment with unemployment at a mere 2.8%. This economic policy has its limits: we are far from the 2% inflation target, which makes the economy vulnerable to a return to deflation in the event of an external shock. The improvement in public finances is pushed back, while the ageing population points to an erosion in the country s external assets (currently 65% of GDP). Tax adjustment targets households via increases to VAT, while corporation tax rates have been severely cut from 40% to 30%, further bloating corporate margins that are already substantial. Lastly, incentives for financial institutions to make their portfolios more international are a double-edged sword: on the one hand, they could trigger uncontrollable capital outflows in the event of a loss of confidence in monetary policy if inflation expectations suddenly soar; on the other hand, Japanese banks have become the largest eurodollar lenders in the world, exposing them to a potential squeeze on dollar liquidity (Quantitative Tightening from the Fed). For now, the Bank of Japan s failure to push up inflation expectations paradoxically safeguards from the risk of outflow for the yen and JGB. Furthermore, capital outflows are restricted by the renewed Japan premium on dollar-yen forex swaps, which reduces the appeal of US bonds once the cost of forex hedging is factored in. So Japanese growth is particularly robust and slanted in favor of corporate profits (wage inertia). It is therefore not surprising that projected earnings growth for listed companies is more than 10%. Valuations for Japanese equities are attractive in our view (Price to Book of 1.4 at fair value, P/E 14x vs. 16x in our model). Lastly, the Bank of Japan continues to buy equities via ETF (JPY6tr in three years). We therefore overweight Japanese equities in our multi-asset portfolios. Risks on this position are primarily political. Japanese growth hinges on momentum in China, but a blip in the Chinese cycle seems improbable in the short term with changes in the make-up of leadership during the Communist Party Congress. However, elections on October 22 have already had an impact on Japanese economic policy: the emergence of a new opposition led by the governor of Tokyo, Yuriko Koike, forced the government to make fresh fiscal pledges (half of the revenue derived from the hike in VAT in 2019 will go to the education budget). Meanwhile, geopolitical threats remain. Japan s trade surplus, inflated by the weak yen policy, could attract ire from the White House, as it did during Reagan s Voluntary Export Restraints. Lastly, Japan is exposed to the risk of an escalation in the North Korean crisis: this issue is a systemic risk for all risky assets (equities, credit), which we partly hedge via our exposure to gold and the dollar.

3 Asset allocation: between Scylla and Charybdis World growth remains close to the 4% trend hit at the start of 2017, and is still highly synchronized across the various geographical areas. World trade, which had long been forgotten in this recovery, reached 5%. Stability of world growth at this high point is particularly remarkable as it is well above its potential, which is estimated at 3.5%. This automatically means that the output gap is narrowing and should put increasing pressure on final prices. The US, Japan, Germany and even the UK pre-brexit are displaying employment rates that are worthy of a full employment situation. The stance from central banks has obviously toughened somewhat in order to keep a grip on inflation projections. The Fed is set to step up its rate hikes and balance sheet reduction in 2018, the ECB should end the PSPP in 9 months next year, the Bank of Japan (BoJ) is to continue winding down its QQE, and the Bank of England (BoE) will extend the monetary tightening cycle probably set to kick off in late The consensus expects a seamless transition to a profile with less abundant liquidity worldwide and steeper yield curves with no major blows for world growth or the price of risky assets. This is also the message that seems to be conveyed by recent performances from growth assets, such as equities, where valuations are reaching record highs, as well as corporate credit. However, the government bond market still seems reluctant to bear out this transition to a reflationary and monetary normalization scenario. The yield curves in G4 countries remain depressingly flat and long-term inflation projections refuse to budge. Our analysis bears out these bond market doubts on the consensus scenario. The much-awaited acceleration in salaries remains elusive in countries close to full employment: globalization, increased flexibility, immigration, more women in the workforce (Japan) and deformation of the capital/work ratio have considerably flattened out the Philips curve. In the US, employment for the age group is still two points short of its 2007 peak, and involuntary part-time work accounts for 2% of the working population. The decline in the capital/work ratio, which reflects more cautious and short-term management by companies aimed at focusing on flexibility, is set alongside a deformation in the structure of jobs towards roles with lower productivity and hence lower hourly wages. This structural shift explains the stark gap between wage growth tracker statistics at constant job structure (Atlanta Fed) and hourly wages reported by the Establishment Survey (AHE). Our estimates point to an acceleration towards 3.7% in wages as measured by the Atlanta Fed (1Q 18), but the AHE, which gives a better indication of the change in purchasing power, should continue to disappoint. Meanwhile, inflation continues to fall short of expectations: core inflation excluding rent fell to 0.9%, a far cry from the 2% target, while rents should slow due to surplus apartments on the market. Lastly, the persistence of positive output gaps elsewhere in the world, in China (excess industrial capacity), the euro area, Brazil, Russia (unemployment) still puts downward pressure on prices for traded goods. The central banks are aware of the risks on their path to their inflation target. So why is there such a major shift in their stance? In a recent statement, Yellen made a major about-turn: she is wary of moving too gradually, which could be as damaging as marching on with normalization too quickly. The FOMC finally seems to be thinking about the risk of bubbles, excessive debt and poor investment decisions resulting from easy money. In previous editions of this publication, we equated this turnaround to a straightforward elimination of the Fed put. For the ECB, the end to the PSPP is forced by the lack of eligible securities and the need to meet the issue share limit of 33% per country, so monetary tightening is political. In Japan, the slowdown in purchases of JGB and the shift to targeting long rates come from the same problem of a lack of securities. Lastly, the BoE is forced to hike rates due to the tightening of the external constraint (record current account deficit, soaring real estate pushing household savings rate towards zero). Monetary tightening for the G4 economies will therefore unfold against a world economic backdrop where wage inflation will still be unable to take over from wealth effects as the driver for private consumption. The impact of monetary tightening will be accentuated by the application of Basel III banking regulations and a probable global shortage of eurodollars (Fed s balance sheet reduction). We think it is unlikely that risky asset valuations will hold up against pressure on US rates heading towards 2.8% as expected by the consensus. By seeking to avoid the specter of inflation, central banks could trigger a fresh crash in 2018 and push the world economy into a deflationary spiral. Our asset allocation factors in this growth projection captive to monetary policy: we maintain our offensive slant in our portfolios, but reduce beta on our equity positions and increase our dollar hedges. 3

4 Equities: still overweight on euro area and Japan Our bull scenario on the dollar implies that trends on the world equity markets remain hinged on the outcome for the US bubble. Our scenario for a surge in the dollar, which we outlined last month, is based not so much on a projection of rate hikes by the Fed but primarily on the Fed s foretold scenario of balance sheet unwinding, which will put increasing pressure on the amount of Fed funds available alongside an increase in US Treasury reserves at a time when non-us banks are forced to build up monetary assets to set against their eurodollars to comply with Basel III LCR requirements. The dollar s increase could also be accentuated by the US multinationals moves to repatriate profits as part of the temporary tax amnesty (corporation tax at around 10%) and the shift to a territorial tax system (one of the foundations of Trump s promised tax reform). The Treasury puts estimates of this windfall at $2,500bn, even if only part of it is repatriated and converted into dollars. A stronger dollar would re-polarize capital flows towards the US to the detriment of emergings. But this capital inflow to Wall Street would be very much like the flight to quality we witnessed after the emerging markets crisis in , which helped sustain the internet bubble until Spring US equities are pricey as reflected in the usual absolute valuations multiples, which are considerably stretched: 12- month P/E of 19.4x (highest since 2002), P/B of 3.2x (highest since 2002), EV/EBITDA at 13.2x (highest since 2000). Optimists may well retort that the risk premium, which compares expected yield on equities over the real 10y government rate, is more reasonable at 5.9%. But the scenario of a seamless normalization that is dominating for 2018 includes both a continuation in EPS growth and a rise in real long-term rates to 1%, i.e. a drop in the risk premium to 5.5% if we take on board unchanged EPS projections for the future, which is equivalent to the level at the end of 1999, just before the dot.com bubble burst. In the short term, investors can reassure themselves by looking at the sound earnings reporting season despite a slowdown in EPS (from 11.2 to 6.5% at this stage in the season). Analysts revisions to future earnings are in line with historical averages. So where could the catalyst for a correction come from? The slowdown in share buybacks is one candidate, another is a geopolitical shock (Korea, oil) and yet another is disappointment on tax reform. Extreme optimism, which is reflected in current volatility levels (historical and implied), household surveys (at their highest since 2002), and the accumulation of short positions on volatility could swiftly transform a minor correction into a dramatic adjustment. Tactical views EQUITIES -- - = + ++ Developed Markets US Europe Japan Asia ex Jap Asia Europe LatAm S&P 500 Equity risk premium & productivity trend : monthly views Emerging Markets : views of the previous month In view of the risk on US valuations and the systemic nature of a potential correction on Wall Street, we reduce the beta on our equity overweight. We neutralize our exposure on emerging Asia due to its dependence on capital inflows from the dollar area. We maintain our overweight on the euro area and Japan, where growth prospects remain very positive and absolute valuations are broadly neutral. The two markets are partly immune to interest rate risk due to their active central banks. In what looks like a paradox merely on the face of it, in view of these risks, we go from negative to neutral on our exposure to the US, which will act as a safe haven in the event of a sharp drop in risk appetite worldwide. We maintain our relative long play on Russia vs. Latin America. Russia s growth is still catching up following the tremors of 2015 (oil, sanctions), driven by the ongoing weak ruble and successful control on inflation projections. Elections in March 2018 should not harbor any major surprises. Conversely, we are relatively negative on Latin America due to risks on industrial metals prices (real estate in China), vulnerability to the Fed s rate cycle and political risks i.e. renegotiations currently under way on NAFTA (Mexico), uncertain structural reforms (Brazil), likely surge in populism at the elections in 2018 (Mexico in June, Brazil in October).

5 Bonds: an impossible normalization? As on the equity markets, the absence of both historical and implied volatility on the bond markets could not be more misleading as this year draws to a close. On the one hand, the Fed is losing its religion on the determining factors behind inflation (the confession from former governor Tarullo is enlightening) and is running scared of the bubbles it has allowed to develop. On the other hand, the ECB and the BoJ will be forced to put an end to their asset purchase programs next year for technical and political reasons, having failed to trigger the expected rebound in inflation. Meanwhile, the BoE is stuck between a real estate bubble, a record current account deficit and the forthcoming upheaval from Brexit, putting it on a very sticky wicket. As a matter of form, we can also add the change in leadership expected at the Fed (4 governors out of 7, including the Chair and Vice-Chair) and the BoJ (governor and deputy governor) in 2018, as well as the ECB in US : non fin.corp. debt growth & Senior Loan Officer Opinion Survey In the same vein as our move to reduce the beta on our equity portfolios, we have tactically adopted a neutral stance on US long-term rates. However, the trend for the US curve over the next 6 months is set to be towards flattening after a possible temporary resteepening. In the short term, expectations of fiscal stimulus (tax cuts), a technical rebound in inflation and the appointment of a more conservative chair at the Fed (Jerome Powell seems to be the favorite to replace Janet Yellen) should lead to a rise in long-term rates towards 2.5%. Beyond this blip, deflationary forces should win out: falling supply of MBS (real estate market seizing up), restriction on bank credit for corporates (demand effect) and households (increase in defaults), imported disinflation due to the dollar s strength (reduction in Fed s balance sheet, repatriation of corporate profits). Lastly, we should not overlook the gravitational effect of European and Japanese yield curves, which are affected by intervention from their respective central banks (these effects will last at least until 3Q 18). In the euro area, the ECB has unveiled plans to scale down its giant bond-buying program while extending it deep into 2018, a gentle policy shift that kept financial markets upbeat. The ECB will continue to buy bonds through September 2018 but from January onwards will cut the pace of its purchases to 30bn a month from 60bn. On the one hand, the Bund market reacted with a drop in rates, since the end to QE was already priced. On the other hand, the ECB has made it clear that if QE is brought to a halt it is not because it achieved its aim (pushing inflation up towards 2% on a long-term basis) but rather due to technical limitations (share issue ratio) and for purely political purposes. Indeed, the decision drew dissent on the ECB s 25-member rate-setting committee: Bundesbank President Weidmann opposed it, worried that the ECB hadn t yet drawn the curtain on quantitative easing despite the eurozone s robust economic In his view, beyond 33%, monetization of government debt would become monetary financing, which is illegal according to European treaties. This approach suggests that by next October the ECB will have run out of options and will not be able to resort to a sovereign QE program in the event of a fresh crisis or deflationary shock. The private debt markets (ABS, covered bonds, corporate credit) do not have enough depth or liquidity to enable large-scale purchases, which means that in a few months time, Draghi s whatever it takes promise will be virtually devoid of meaning. The euro area will have to get through the next few bumpy patches (due to political risks in particular) without this monetary safeguard. This suggests a potential for renewed widening of peripheral spreads at some point next year. We continue to underweight sovereign debt in the euro area. Tactical views Fixed income Euro Core Euro Periph UK Source: Datastream -- - = + ++ Sovereign Bonds US Japan Inflation Euro IG US IG High Yield $ High Yield EM Debt : monthly views Credit : views of the previous month We are revisiting European high yield this month. This position reduces the risk involved in our overweight stance on risky assets in the euro area (overweight on equities) and moderates the extent of our short duration play. 5

6 Commodities: long gold versus oil and industrial metals Oil has benefited over recent weeks from the surge in geopolitical risks (clashes in Iraqi Kurdistan, Trump s threats to rip up Iran nuclear deal, Libyan oil field shutdown, risk of default for PDVSA in October/November), as well as the perception of strong world growth, a reduction in OECD inventories and the weak dollar. Brent Forward curve & inventory level The recovery in Brent took place alongside a significant increase in long speculative positions on the ICE futures exchange. These financial flows broadly inverted the Brent curve, which is now on a backwardation configuration. This inversion in the curve already factors in a return in OECD stocks to below their five-year average, contradicting projections from the IEA. The market seems to be pricing in an extension in the OPEC+ agreement in 2018, and ongoing robust growth in oil demand. We think that this scenario is overly optimistic and the move on the forward curve seems exaggerated by carry plays now that the roll on futures positions offers positive yield. In an optimistic scenario where demand remains on a 1.4% trend, the world market would automatically be balanced out by the rise in non-opec supply. Current prices leave no room for the risk of disappointment on demand, compliance with the OPEC+ agreement to limit production or an offensive reaction from US shale oil producers to higher prices. The price differential between US WTI and North Sea Brent reflects this excessive speculation on Brent. The effects of the hurricane season are easing, but the WTI-Brent differential remains abnormally high in view of transport costs and the rise in exports of US light crude. The WTI futures market probably saw a wave of hedging by shale producers, which kept a lid on speculative pressure on WTI prices, while this phenomenon is absent from the Brent market. This abnormal spread is a Tactical views Source: Datastream Commodities -- - = + ++ reminder of US shale producers great capacity to react to market changes. Marginal costs stand at around $50/bbl, and the corporate credit market for now remains wide open to frackers who wish to invest. The number of derricks in operation has admittedly dropped, but producers have close to 5,000 drilled but uncompleted wells that can be developed to boost production. For such times as the bubble on US HY credit lasts, the WTI futures curve should remain rooted at around $50/bbl and act to keep Brent down. In view of the market s very optimistic stance, our scenario for an easing in world growth next year and a rebound in the dollar points to a continued short position on Brent. Geopolitical risks admittedly remain high (separatist tension in Iraqi Kurdistan, renewed sanctions against Iran, sharp drop in production at PDVSA in the event of default) and the defeat of IS at Raqqa paradoxically paves the way for direct confrontation between Syrian factions backed by regional powers (Turkey, Saudi Arabia, Iran) and global players (US, Russia). But in the short term, these pockets of tension could prompt struggling OPEC members to take advantage of the situation and unilaterally increase their production (Iran, Iraq, Qatar). We also know that Saudi Arabia is the main sponsor of the OPEC+ agreement, as the kingdom needs high prices to optimize profits from the partial privatization of Saudi Aramco. The country had to make concessions to Russia to ensure support from Moscow to renew the agreement, but authorities may decide that the cost of the agreement is too high and throw in the towel in 2018, as suggested by rumors of a delay in the IPO to 2019 and a private placement to sovereign wealth funds. We maintain gold as a geopolitical hedge on our short oil position. Gold is also a medium-term play on the drop in US longterm rates. In the short term, gold could be hit by a rebound in the dollar and the increasing use of Bitcoin as an alternative currency devoid of sovereign risk. We maintain our short position on industrial metals. Despite a strong world growth context, metals prices should suffer from the surge in the dollar and the easing in Chinese demand for the building sector. Our favorite indicator on the Chinese real estate cycle is growth in sales in terms of floor area and this statistic continued to slow in September, to 10% vs. 33% a year ago. Oil Industrial metals Gold : monthly views : views of the previous month

7 Quantitative Indicators ECONOMIC SITUATION Poor e Good This continuous indicator, which stands between -1 and +1, allows us to assess the world economic outlook. It is based on the level and/or momentum of a range of macroeconomic data (growth, inflation, valuation, earnings). The higher this indicator, the more we favor risky assets. MARKET TRENDS Downtrend e Uptrend This continuous indicator, which stands between -1 and +1, reflects medium-term momentum on the equity markets relative to the fixed income markets. It is based on moving averages of variable length, defined on the basis of volatility. If the indicator is positive, we prefer risky assets. RISK APPETITE Low e High This continuous indicator, which stands between -1 and +1, shows the extent to which various market players are looking for risk in the short term. It is based on an analysis of the level of risk (measured by volatility) and how it is remunerated by the market (measured by premiums or spreads). The higher this indicator, the more we favor risky assets. 7

8 FLOW Outflow e Inflow This flow indicator measures the investor sentiment for equities, bonds and money markets, calculated using investor flows (data from EPFR) and volumes. The indicator is continuous and lies between -1 and 1. How to interpret this indicator: When the indicator enters into positive territory, we favor risk assets AGGREGATED INDICATOR Risk OFF e Risk ON Our proprietary aggregated indicator is a measure of the equiweighted average of our 4 signals: Economic Outlook, Market Trend, Risk Tolerance and Flow. The indicator is continuous and lies between -1 and 1. How to interpret this indicator: When the indicator enters into positive territory, we favor risk assets

9 Model portfolio Asset classes Benchmark Current portfolio Deviation/ benchmark Change/ previous month Cash 10.0% 18.0% 8.0% Eonia 10.0% 18.0% 8.0% EUR / USD % -2.5% USD / CHF - 2.5% 2.5% EUR / SEK % -1.0% Governement bonds 40.0% 22.0% -18.0% Euro 32.0% 16.0% -16.0% Euro Inflation 4.0% % US 4.0% 4.0% Gilt - - Italy - 2.0% 2.0% Spreads 15.0% 21.0% 6.0% Euro Credit 15.0% 15.0% Euro High Yield - 4.0% 4.0% US High Yield - - CB Euro - 2.0% 2.0% Emerging bonds - - EMD $ - - Developed equities 20.0% 25.0% 5.0% EMU 2.0% 4.5% 2.5% Europe ex-emu 3.0% 1.0% -2.0% North America 12.0% 12.0% Japan 2.0% 5.0% 3.0% Pacific ex-japan 1.0% % Euro SmCap - 1.0% 1.0% Euro Banks - 1.5% 1.5% Emerging equities 10.0% 10.0% Emerging Asia 7.0% 7.0% Latam 1.5% 0.5% -1.0% EMEA 1.5% 0.5% -1.0% Mexico - 1.0% 1.0% Russia - 1.0% 1.0% Commodities 5.0% 4.0% -1.0% Energy 2.5% 1.5% -1.0% Industrial Metals 1.3% 0.3% -1.0% Precious Metals 1.3% 2.3% 1.0% 100.0% 100.0% - - 9

10 Contributors Coordination by the multi-asset allocation department: the Investment and Client Solutions division of Natixis Asset Management Franck Nicolas Head of Investment and Client Solutions Raphael Gallardo Multi-asset strategist - Investment and Client Solutions Written on October 27, 2017 Click here to view the Natixis Asset Management financial glossary Natixis Asset Management Limited liability company - Share capital 50,434, Regulated by AMF under no. GP RCS Paris n Registered Office: 21 quai d Austerlitz Paris Cedex 13 - Tel This document is intended for professional clients only. It may not be used for any purpose other than that for which it was intended and may not be reproduced, disseminated or disclosed to third parties, whether in part or in whole, without prior written consent from Natixis Asset Management. No information contained in this document may be interpreted as being contractual in any way. 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