For professional investors Asset Allocation Monthly December 2015 Joost van Leenders, CFA, Chief economist, Multi Asset Solutions joost.vanleenders@bnpparibas.com +31 20 527 5126 SUMMARY INVESTMENT CLIMATE ECB and the Fed ready to move Chinese renminbi IMF SDR basket Asset allocation de-risked The positive return on global equities in euros in November was entirely due to the euro weakening versus the US dollar. In US dollar terms the MSCI World All Countries equity index fell by 1.0%. The weakening of the euro is of course related to two impending major events in monetary policy in December: the ECB policy meeting early in the month and the Federal Reserve (Fed) meeting on the 15th and 16th. Looking towards 2016, we foresee modest growth and low inflation. This is an investment climate which is typically positive for corporate bonds. We are currently over in US and European highyield bonds. Following the equity rally in October we have derisked our portfolios somewhat by going under emerging equities. ECB and the Fed ready to move Multi-asset Duration Investment grade High yield Emerging market debt Real estate Commodities Monetary policy divergence between the US and Europe is not unprecedented, but the last time was more than two decades ago. In early 1994 the Fed started a hiking cycle which lasted about a year and took the fed funds rate from 3% to 6%. During that same period the German Bundesbank cut rates by 100 basis points to 5.25%. This time the divergence in rates will be far less dramatic. It is very likely that the Fed will hike rates in December. The minutes of the October Federal Open Market Committee (FOMC) meeting showed that the doves are now a minority in the monetary policy-setting committee. But the path of rate hikes will be gradual: 125 basis points through the end of next year according to the median forecast of Fed
Asset Allocation Monthly December 2 policymakers and about 75 basis points according to futures markets. The ECB will most likely keep the refi rate unchanged at 0.05%. However, the ECB will most likely expand and extend its quantitative easing programme. It will also likely cut the deposit rate further into negative territory, penalising banks for holding reserves at the central bank. 20 16 12 8 4 US and eurozone official rate 0 60 65 70 75 80 85 90 95 00 05 10 15 Fed funds Repo / Refi So the divergence may have an impact on markets, but most of it should be discounted. Markets price a 74% chance of a Fed rate hike in December. ECB officials have been vocal on their intent to add stimulus, even though economic numbers have continued to signal slightly above-trend growth. Inflation is just too low for comfort. Thus, the euro has weakened to close to the lows this March, which were driven by the ECB s first round of quantitative easing. The euro could weaken slightly further if the ECB and the Fed deliver, but over the course of 2016 it may gain some ground if the eurozone economy continues its gradual recovery. Chinese currency part of the IMF s Special Drawing Rights Special Drawing Rights (SDRs) mainly function as a unit of account for the International Monetary Fund (IMF). SDRs are allocated to countries by the IMF and represent additional foreign exchange reserves. SDRs can only be converted in one of the currencies in its basket. On 30 November the IMF decided that the Chinese renminbi will be included in the SDR basket. From 1 October 2016 it will make up 10.9% of the SDR basket. The of the US dollar will stay largely unchanged at close to 42%, but the of the euro will fall by 6.5 percentage points to 30.9%, the Japanese yen s will fall by 1.1 percentage points and the British pound s by 3.2 percentage points. According to the IMF, the inclusion of the renminbi will make the SDR more stable and more representative. For inclusion in the SDR basket, a currency must be freely usable, but not freely floating or fully convertible. The limited convertibility of the renminbi is clear; whether it is freely usable is a matter of discussion. The renminbi is not widely used in international trade and not widely traded in foreign exchange markets. While its inclusion pays tribute to China s increased importance in the global economy and acknowledges that financial reform has progressed, the investment implications are limited. It will not lead to strong demand for renminbi. If anything, it will help to establish a benchmark official interest rate in China, which should lead to more transparency in monetary policy. De-risking our asset allocation Last month we wrote that we were not convinced of the market rally in October. 130 120 110 100 90 (Local currencies, index, 1 january 2015 = 100) 80 Jan-15 Mar-15 May-15 Jul-15 Sep-15 S&P 500 DJ Eurostox Nikkei 225 MSCI EM in $ We benefited through some low-cost option strategies, but we left our exposure to global equities at neutral. We preferred to take risk though overs in US and European high-yield corporate bonds. For clients who cannot invest in US highyield bonds we recommend an over in European equities. These views have not changed. And we think they may be largely appropriate for 2016 as well. Low growth and low inflation are traditionally more beneficial for corporate bonds than for equities. 120 80 40 0-40 12 months forward EPS (% YoY) -80 06 07 08 09 10 11 12 13 14 15 US Europe Japan Emerging markets
Asset Allocation Monthly December 3 US equities should benefit from stronger growth and inflation, but financial engineering corporates borrowing to sustain dividends and share buybacks makes us more cautious. Margins in the US are also high and may be difficult to sustain as the labour market continues to strengthen and starts to create upward pressure on wages. Margins in Europe are low; giving stronger operational leverage to growing sales, but growth and inflation will be even lower than in the US. In corporate bonds we think most of the returns will come from the coupons. We have held to the US high-yield position, even though the deterioration in balance sheets due to financial engineering warrants vigilance. disappointing. The increase in the small cap over is funded preferentially out of US real estate, but due to a lack of this asset class in some of our portfolios we use global real estate as an alternative. Our negative view on global real estate is driven by the US where we think the asset class is expensive. We also think that Fed tightening hangs over this interest-sensitive asset class. This may be reflected not just in US real estate, but also by US dollar-linked real estate in Asia. 1000 Corporate financial flows (USD bn, SAAR) 500 0-500 -1000 90 95 00 05 10 15 Borrowing Net equity issuance Dividends Although our broad views have not changed, we have derisked our asset allocation through an under in emerging market equities. We have not seen a convincing turnaround in emerging growth indicators. Analysts generally expect earnings per share to fall next year. Relative to developed markets, companies returns on equity have been falling since 2011. Private sector debt has surged in a number of countries and the appreciation of the US dollar and rising interest rates in the US pose a risk for emerging market debt. Emerging assets and currencies have suffered, so a negative view is discounted, but given our large strategic exposure to emerging market assets, we chose emerging market equities for a tactical under. We have increased our exposure to European small caps. Small caps have done better than large caps since the middle of the year when the prospects of the European economy held up well relative to emerging markets. This makes sense as small caps are less exposed to emerging markets than large caps are, and more exposed to the domestic cycle. Small caps are still expensive relative to large caps, but in the latest earnings season large caps earnings and revenues were more
Asset Allocation Monthly December 4 Asset allocation 1 Fixed income Multi-asset Duration Investment grade High yield Emerging market debt Real estate Commodities Euro Govies Euro Short Dated US Govies Investment Grade (EUR) Investment Grade (US) Investment Grade (US) Euro Inflation Linked High Yield (EUR) High Yield (USD) Emerging Bonds USD Emerging Bonds Local Ccy 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 Foreign exchange AUD CAD CHF DKK EUR GBP HKD JPY NOK NZD SEK SGD USD EM FX KEY Over: Neutral: Under: Increase: No change: Decrease: 1 The tables reflect net positions versus the benchmark within the Multi Asset Solutions 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 December 5 Neutral Changed. We foresee modest growth and low inflation. In such an environment companies may struggle to increase sales, margins and ultimately profits. The disappointing sales results in the third quarter underpin this view. Low interest rates may be beneficial, but we do not know how market will respond to rate hikes in the US. Financial engineering, i.e. borrowing to sustain dividends and share buybacks have underpinned US equities. US companies are highly profitable, but analysts earnings expectations are negative. In Europe margins are low, but profits have yet to benefit from the economic recovery. We de-risked our portfolio by going under emerging equities. These equities may struggle with rate hikes in the US, an expensive dollar and rapid increases in private sector debt. Small-cap equities: Over Changed. We increased our over in European small cap equities. We are now over versus European large caps and versus US real estate. The over versus large caps is based on our desynchronised growth scenario: a cyclical upswing in the US and the eurozone, but relatively weaker growth in emerging economies. Large caps have significant exposure to emerging markets, which have not shown any rebound so far. Ample liquidity also supports small caps and the earnings outlook is favourable, in our view. Government bonds: Neutral duration Unchanged. Near-term changes in monetary policy a package of easing measures in the eurozone and a rate hike in the US are widely discounted, we think. US Treasuries look quite fairly valued taking expected growth, inflation and monetary policy into account. German yields look low relative to the growth and inflation outlook, but the ECB s asset purchases keep a lid on upward pressures. Thus, while yields are low, we do not see them rising much soon. Investment-grade corporate bonds: Neutral Unchanged. We see the macroeconomic fundamentals as positive for this asset class. Defaults remain subdued, while credit conditions continue to improve in the eurozone and yields remain historically low. With investment-grade bonds in the eurozone excessively valued relative to high-yield credit, we prefer high-yield. High-yield bonds Over Unchanged. High-yield corporate bonds should benefit from the low growth, low inflation and low yield environment. ECB asset purchases are actively crowding out investors amid shrinking net government bond supply, which could create a scarcity premium for euro fixedincome instruments. We are getting more cautious on US high-yield due to weakening balance sheets, but have kept our over as issuance has fallen. Emerging market bonds Neutral Unchanged. The fundamentals for emerging market bonds have deteriorated in the past years. The unwinding of the commodity super cycle and of strong credit growth in a number of emerging economies pose downside risks. However, spreads are still high and the positive carry makes an under position costly. Real estate securities: Under Changed. We believe in real estate fundamentals such as attractive dividend yields, positive supply factors and low funding costs. However, valuations rose earlier this year and interest rate volatility is a risk. We are therefore under US real estate.
Asset Allocation Monthly December 6 Commodities Under Unchanged. Overall commodity prices have fallen to their lowest levels for many years. Supply is ample and demand growth limited. The carry on the asset class is negative, but an under would expose an investor to the risk of a rebound. In our view this justifies a neutral stance.
Asset Allocation Monthly December 7 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 96002, a simplified joint stock company with a capital of 67,373,920 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.