For professional investors Asset Allocation Monthly June 2014 US rebound confirmed, little signs of improvement in emerging economies More cautious on equities, but still over Asset allocation: now over emerging market debt in local currency Multi-asset Equities Duration Investment grade High yield Emerging market debt Real estate Commodities Joost van Leenders, CFA Chief Economist, Multi Asset Solutions joost.vanleenders@bnpparibas.com +31 20 527 5126 MARKET REVIEW Economy In the United States, in both manufacturing surveys and hard data, signs have emerged of a rebound in activity after the first-quarter freeze-up (when GDP shrank by an annualised 1% %). April consumer and producer figures do not necessary point to a spectacular acceleration, but the upward revisions of previous months are providing some momentum for the second quarter. Inflation surprised on the upside (2% year-onthe Fed year in April, vs. 1.5% in March), but this did not keep from reiterating its intention to keep key rates low for some time to come. US prices (% YoY) 10.0 7.5 5.0 2.5 0.0-2.5-5.0-7.5 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 Consumer prices Producer prices
Asset Allocation Monthly June 2014 2 In the euro zone, growth was sluggish in the first quarter (0.2%) with wide disparities between its largest economies (up 0.8% in Germany and 0.4% in Spain, flat in France and a slight contraction in Italy). This disappointed hopes of about 0.5% growth that had been raised by activity surveys. Against this backdrop, the ECB s statements that it was comfortable with the idea of acting in June fed expectations of an aggressive move to keep inflation (0.7% year-on-year in April) from staying too low for too long. In Japan, as expected, consumer spending boosted activity in the run-up to the 1 April VAT rate hike. Productive investment also did well, and activity indicators weakened but did not collapse. Companies expect growth to dip in the second quarter but do not expect this to last long, which could cause the Bank of Japan to postpone the announcement of a massive easing in its monetary policy. The economic situation in emerging markets is beginning to show tentative signs of improvement, particularly in exports, which appear at last to be reacting to the acceleration in demand from developed economies. Legislative elections in India resulted in a clear victory by the Bharatiya Janata party led by Narendra Modi. The new prime minister s absolute majority could make it easier to put through reforms. In Thailand, the military took power after a seven-month-long crisis. In Ukraine, pro-western forces won the presidential election but the eastern part of the country is still under the control of pro-russian separatists. Equity markets 1 After some tentativeness early in the month, equities continued to rally in May. The MSCI AC World index (in dollars) gained 1.8%, while emerging markets managed to make up the ground they had lost on the year to date. The MSCI Emerging index (in dollars) rallied by 3.3% in one month, thus bringing its year-to-date gain to 2.5%, almost the same as global equities (+3.2% by the MSCI AC World over the same period). This trend was driven mainly by central bank reassurances that they would keep their monetary policies highly accommodating, which overshadowed political and geopolitical factors in particular. For example, investors mostly shrugged off the European election results (including the low turnout and the success of Euro-sceptical parties in several countries). Nor did they react for very long to the violent conflicts in Ukraine 1 Unless otherwise mentioned, all indices are in local currency. during the presidential election, or to other geopolitical events. Equities were driven by the economic outlook and by liquidity. 1800 1700 1600 1500 1400 1300 1200 1100 Within the euro zone, the German index gained 3.5% (vs. 1.4% by the Eurostoxx 50 and 0.7% by the CAC 40, which was hit late in the month by the banking sector s difficulties). This outperformance was driven by a combination of solid German economic growth and the receding of the Ukrainian risk as perceived by investors. In the US, the S&P 500 set a new record, closing above 1920 points on 30 May, while the Fed stuck to its cautious stance on employment and recalled that the normalisation of key rates is not for any time soon and will remain a slow process. The S&P 500 ended the month up by 2.1%, driven by tech and telecom stocks, which somewhat offset the poor performances of April. After declining on the year to date, the Tokyo market turned up in May. The broad Topix index gained 3.4%, although the yen s value was flat, thanks to a strong showing by the financial sector. Bond markets MSCI World (ex EM) & MSCI EM Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 MSCI World (lhs) MSCI EM (rhs) 1200 1150 1100 1050 1000 950 900 850 Early in the month, the yield on the 10-year US T-note was relatively stable at about 2.60%, despite solid 2 May jobs report. Investor positioning is probably the main reason for these hesitations. The yield then began to recede faster after the release of several figures (e.g., retail sales and industrial output) deemed slightly disappointing, given that a rebound was widely expected for the second quarter after bad weather earlier in the year. The 10-year yield thus fell below 2.50% on 15 May, ending the month at 2.48%, i.e., 17bp lower than at the end of April. Investor reaction to rather encouraging indicators (durable goods orders and consumer confidence) released during the last week of May was muted. In the euro zone, government bonds continued to be sought out during the
Asset Allocation Monthly June 2014 3 month. In mid-month, peripheral markets came under heavy selling for a few days. This profit-taking triggered renewed interest in German bonds. The yield on the 10-year Bund pulled back to 1.30% on 15 May a one-year low before ending the month at 1.36%, 11 bp lower than at the end of April. been no further ripples. Although emerging equities are still lagging developed equities, they have done relatively well lately. Emerging currencies, which had suffered from the tapering talk, have also been less volatile. We expect the warm blanket of monetary policy to remain in place for a while. 4 3 2 1 Ten-year government bond yields 0 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 US Germany Japan Ten-year Italian and Spanish yields fell by 11bp and 17bp, respectively, between the end of April and the end of May. This was driven partly by Standard & Poor s upgrade of Spain s sovereign rating to BBB, while, in Italy, the big victory of the party of Prime Minister Matteo Renzi during the 25 May European elections reassured investors and sent the 10-year yield under 3% by month-end. The narrowing trend in investment grade corporate spreads stalled in May, while high yield spreads widened slightly. INVESTMENT CLIMATE Despite a brief correction in January, equities, real estate and commodities have all gained so far this year, while bond yields have fallen, most strongly in peripheral eurozone economies. At this point, we do not see any strong signs that this benign investment climate could change soon, although we remain alert. Monetary policy: still supportive The US Federal Reserve is steadily tapering its asset purchases. After some market unrest when the plans were first mentioned and when tapering actually started, there have 500 400 300 200 100 Central bank balance sheets (Index, January 2008 = 100) 0 08 09 10 11 12 13 14 US Eurozone UK Japan It is now widely accepted that the Fed will start hiking rates in the second quarter of next year, but it has convinced markets that it will do so gradually and that rates will not be pushed up as much as in previous cycles. The ECB is turning more stimulative to raise inflation. It is likely that rates will be on hold for a long time or that policy could loosen further. The Bank of Japan has signalled that calls for additional quantitative easing are premature, but it may be too optimistic on the economic outlook and inflation. The People s Bank of China has implemented easing measures and while current inflation would allow it to do more, this looks unlikely since the PBoC is trying to slow credit growth. Is it just about monetary policy? We think the positive mood on markets is also due to yields being low (because inflation is low). This should not change in the eurozone. The return of Japanese inflation might not last. If inflation in Japan does turn up more decisively and yields follow, we think the Bank of Japan has no choice but to buy more bonds to keep the government s interest burden from becoming unbearable. The US is now in a strong rebound from the weak first quarter. The ISM manufacturing index, consumer confidence and capital goods orders have all improved. The labour market is doing well. Growth could slip in the second half, but this is not bothering markets now. If there is one positive aspect from the large slack in the European economy,
Asset Allocation Monthly June 2014 4 it is that it can grow for a long time before reaching capacity constraints. Trade has done well and improving PMIs and consumer confidence could indicate that growth is broadening. There are signs of improvement in emerging markets such as a stronger PMI in China and stronger export growth in some cyclical Asian economies, but these signs are still meagre. 80 70 60 50 40 30 20 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 ISM new orders (lhs) US ISM & durable goods orders Dur. goods orders (% YoY, rhs) 39 26 13 0-13 -26-39 Cautiously over equities We have not changed our over in equities, although our conviction has deteriorated somewhat given the rich valuations in the US, lacklustre growth in the eurozone and the cooling housing market in China. For now, the growth outlook and monetary policy should support markets, but we are watchful. We think it is still too early for an over in emerging equities. While growth is stabilising and possibly improving, this is not widespread. Earnings growth is still low. But the improvements were enough for us to over emerging market bonds in local currency. They provide positive carry while the downside risks to growth are diminishing.
Asset Allocation Monthly June 2014 5 Asset allocation 2 Multi-asset Equities Duration Investment grade High yield Emerging market debt Real estate Commodities Fixed income Euro Govies Euro Govies AAA Euro Short Dated Corporate bonds (EUR) Euro Inflation Linked High Yield (EUR) High Yield (USD) Emerging Bonds USD Emerging Bonds Local Ccy Equities European large caps European small caps US large caps US small caps Japan Emerging markets Real estate European Real Estate US Real Estate Asian Real Estate KEY Over: Neutral: Under: Increase: No change: Decrease: Foreign exchange AUD CAD CHF DKK EUR GBP HKD JPY NOK NZD SEK SGD USD EM FX Summary outlook Cautious Fed tapering and an improving outlook reduce the risk from the normalization of monetary policy in the US. The Fed will start hiking rates in the middle of 2015, but the Fed is keen to prevent sudden increases in longer-term yields. This is not 1994 all over again. Europe remains vulnerable amid high debt and a lack of growth, despite the improvement in European economic data lately. Monetary policy can provide an anesthetic for markets, but the lack of growth is steadily undermining political consensus and democratic legitimacy. With the ECB in the background systemic risk may be contained, but the intrinsic problem of unsustainable debt burdens has not been resolved and may flare up again. There will be steady downward pressure on wages and prices until unemployment subsides. The clear consensus is that the second half of 2014 will be good for global growth, especially in the developed world. However, the economic cycle is definitely not strong, with the US only in a short-term rebound. The lingering effect of higher private sector debt in China will not disappear quickly, while growth in other emerging markets is modest by historical standards. 2 The tables reflect net positions versus the benchmark within the MAS strategy model portfolio. Views on a particular asset class should not be seen in isolation but in the context of the overall portfolio. * Duration risk is managed independently of the underlying fixed income allocation using government bond futures.
Asset Allocation Monthly June 2014 6 Equities Over Unchanged. Our over in equities is based on stronger expected economic growth and corporate earnings and still-low interest rates. Further tapering of its quantitative easing by the US Federal Reserve is now largely discounted in our view, but the ECB and the Bank of Japan may loosen policy further yet. However, rising equity valuations, low market volatility and modest realised earnings growth have made us more cautious. We are neutral on all regions. We want to see stronger growth in emerging markets before moving to an over, although valuations remain attractive. Small-cap equities: Neutral Unchanged. We think the economic cycle in general benefits small caps, but valuations are stretched and now amply discount the developing mergers & acquisitions cycle. The earnings outlook relative to large caps is positive in Europe in our view, but neutral in the US. Government bonds: Neutral duration Unchanged. In Europe, the main issue for markets is low inflation and the ECB s possible reaction. Since the economy is improving and the main adjustments in labour costs may be behind us, there is room for German yields to drift higher, but we are neutral duration given the uncertainty about the impact of any ECB actions. For the eurozone as a whole, yields have fallen due to continuing declines in peripheral member states, but we do not see much room for even lower levels. Investment-grade corporate bonds: Neutral Unchanged. We think these bonds are expensive even though the economic outlook and credit conditions are neutral and there are fewer downgrades of investment-grade credit. So we prefer other fixed-income categories. High yield bonds Over Unchanged. We expect defaults in the European high-yield segment to remain generally low. Bonds could benefit from further ECB policy easing. We also like the coupon yield. Fed tapering may cause yields to rise, but since we implemented our over versus government bonds, which usually have a much longer duration, any yield increase should be hedged. Emerging market bonds Over Changed. We are over in local currency bonds given the attractive yields and now that volatility has fallen and geopolitical tensions have receded. We also think global liquidity is beneficial. Real estate securities: Neutral Changed. Improving fundamentals such as falling vacancy rates have been now priced into US property, but we don t see valuation as positive, while US real estate is vulnerable to higher bond yields. We prudently took profit on our over in European real estate after a strong performance of the asset class even though we still think that the fundamentals appear likely to start improving.
Asset Allocation Monthly June 2014 7 Commodities Neutral Unchanged. Commodity prices have not moved much in recent months. Base metals have broadly followed growth trends in emerging markets, with some improvement recently. Fundamentally, we think the outlook is mixed: improving economic growth in the US and Europe could boost demand, but slower growth in China is negative. Stronger demand may not suffice to absorb rising supply. The cost of holding this asset class in a low-yield environment remains negative, in our view.
Asset Allocation Monthly June 2014 8 Disclaimer This material is issued and has been prepared by BNP Paribas Asset Management S.A.S. ( BNPP AM )* a member of BNP Paribas Investment Partners (BNPP IP) **. This material is produced for information purposes only and does not constitute: 1. An offer to buy nor a solicitation to sell, nor shall it form the basis of or be relied upon in connection with any contract or commitment whatsoever or 2. Any investment advice. Opinions included in this material constitute the judgment of BNPP AM at the time specified and may be subject to change without notice. BNPP AM is not obliged to update or alter the information or opinions contained within this material. Investors should consult their own legal and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing in the Financial Instrument(s) in order to make an independent determination of the suitability and consequences of an investment therein, if permitted. Please note that different types of investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment may either be suitable, appropriate or profitable for a client or prospective client s investment portfolio. Given the economic and market risks, there can be no assurance that any investment strategy or strategies mentioned herein will achieve its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the Financial Instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The different strategies applied to the Financial Instruments may have a significant effect on the results portrayed in this material. The value of an investment account may decline as well as rise. Investors may not get back the amount they originally invested. The performance data, as applicable, reflected in this material, do not take into account the commissions, costs incurred on the issue and redemption and taxes. * BNPP AM is an investment manager registered with the Autorité des marchés financiers in France under number 96-02, a simplified joint stock company with a capital of 64,931,168 euros with its registered office at 1, boulevard Haussmann 75009 Paris, France, RCS Paris 319 378 832. www.bnpparibas-am.com. ** BNP Paribas Investment Partners is the global brand name of the BNP Paribas group s asset management services. The individual asset management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner. www.bnpparibas-ip.com