For professional investors Asset Allocation Monthly April 2016 Joost van Leenders, CFA, Chief economist, Multi Asset Solutions joost.vanleenders@bnpparibas.com +31 20 527 5126 SUMMARY INVESTMENT CLIMATE US no recession but modest growth No decisive rebound in manufacturing yet ECB and Fed more dovish Markets may be complacent US equity markets continued their rally in March, while in Europe and Japan, the rally which had been less convincing anyway petered out. Emerging equities continued to do well. Government bond yields fell in the US, Germany and Japan. Spreads on corporate bonds tightened. We think there were two main drivers for these developments. Firstly, fears of weak growth and even a US recession ebbed and secondly, monetary policy could be more stimulative than thought previously. We remain cautious on the outlook for economic growth and corporate earnings, while not that much has changed regarding monetary policy. After the rally, we went under global equities, with a preference for an under in Europe. We reduced our over in US high yield and we are now under emerging market debt in hard currency versus US Treasuries. Modest growth in the US Multi-asset Duration Investment grade High yield Emerging market debt Real estate Commodities Active s Markets have come round to our view that the US is not on the way to recession. We simply do not see any recession triggers. In fact, recent data has surprised positively, mainly on manufacturing, where producer confidence has improved quite sharply and production has accelerated. Still, not all signals are green. Orders and shipments of capital goods had trended sideways from mid-2014, but have weakened recently. One reason could be high inventories relative to sales.
Asset Allocation Monthly April 2 75 70 65 60 55 50 45 05 06 07 08 09 10 11 12 13 14 15 16 Orders Shipments Consumer sentiment has topped out. Consumers have been cautious in their spending. First-quarter GDP data has yet to be released, but growth appears to be stuck close to the meagre 1.4% QoQ annualised of the fourth quarter of last year. Consumer fundamentals such as income growth and wealth look healthy, supporting growth. More frugal consumers are positive from a longer-term perspective: more modest spending should diminish the risks of imbalances. But it may also prevent faster growth. We believe the underlying problem is low productivity growth, which is not just a US issue. Manufacturing rebound? US capital goods (excl. defense & aircraft, USD billion) Source: Datastream, BNPP IP In March, the US ISM-manufacturing index jumped to above 50 entering growth territory for the first time since last September. The Markit PMI, which we use to calculate the aggregates for developed economies and the world, improved by less, but both indices are now at comparable levels, pointing to modestly positive growth in the sector. Our global GDP-ed manufacturing PMI rose to 50.9 in March with a modest advance in developed economies and a bigger gain in emerging markets. In emerging markets, the index touched 50 after almost a year in contraction territory. Production data has also shown signs of life recently. Annual growth turned positive in South Korea, Chile and India and was less negative in Taiwan and Russia. This could be a sign that global economic growth is improving. However, China s economy is bottoming only tentatively and some eurozone leading indicators have peaked. Moreover, there have been other mini-cycles in manufacturing in recent years, so we need more evidence before we become more positive on global growth. Monetary policy, again Despite all the expectations for more monetary easing in March, the ECB still managed to surprise positively, even though the initial market reaction was mixed. The efficacy of more easing can certainly be questioned with interest rates as low as they are, but an increase in the monthly asset purchases to EUR 80 billion, a broadening of the scope of eligible assets to some corporate bonds and a new loans programme under which banks can borrow at zero per cent or even negative interest rates should at least be positive at the margin. At the Federal Reserve, chair Yellen surprised with a dovish speech recently, describing the US economy as somewhat mixed and stressing downside risks such as the modest pace of global growth, developments in China and a more uncertain inflation outlook. We would agree with some caution on inflation given the lack of wage pressure in the US labour market and the disinflationary influences from abroad. Yellen repeatedly stressed that this setup calls for gradual increases in interest rates. What is clear to us is that she wants to see more stable global markets and commodity prices and does not want an overly strong US dollar. 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 US Fed funds rate Mar-2015 Dec-2016 Dec-2017 Dec-2018 Fed December projections Fed March projections Fed futures at 30 March Source: Federal Reserve, Bloomberg, BNPP IP Why did she decide to sound so dovish? Fed forecasts for policy tightening had already been toned down and markets saw even less of a need for higher rates. It is likely that she wanted to show leadership after other Fed officials had recently argued for rate increases. It is clear that she does not favour an early hike. As opposed to other policymakers, Yellen may have a more global perspective, especially when it comes to inflation. Looking just at the Fed s objectives low unemployment and inflation at around 2% one could easily argue for higher rates. However, even the current 5.0% unemployment rate has not sparked inflation. This would support her gradual approach to policy tightening. We
Asset Allocation Monthly April 3 believe a hike in April is virtually off the table, but action in June is still possible followed by one more move this year. Are markets becoming complacent? With US equity markets near record highs, risk spreads narrowing and emerging currencies appreciating, one could ask whether markets are becoming complacent. 105 100 95 90 85 80 Emerging currencies (index versus USD, 1 January 2015 = 100) 75 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Asia* EMEA** LatAm*** * Simple avg. of KRW, INR, IDR, THB, TWD, SGD, MYR, PHP ** Simple avg. of TRL, RUB, ZAR Source: Bloomberg, BNPP IP We think so. As said, we don t think the Fed has given up on further rate hikes this year and discounting additional tightening could push bond yields higher and equities lower. As for the ECB and the Bank of Japan, markets have been quite sceptical on additional easing and especially on more negative interest rates. Such rates can dent banks earnings (even though in Japan, this is mitigated by a tiered interest-rate structure and in the eurozone, by the ECB s loan programme under which negative rates may also be applied). Analysts have cut their expectations for corporate earnings, which may cause positive surprises when first-quarter results are reported, but we don t see these dynamics as particularly positive. So, after equities rallied, we went under global equities. We prefer to be under notably in the eurozone where low growth and inflation make it particularly hard to grow earnings. 110 105 100 95 90 85 80 75 (local currencies, index, 1 January 2016 = 100) Jan-16 Feb-16 S&P 500 DJ Eurostox Nikkei 225 MSCI EM in $ Source: Datastream, BNPP IP We implemented an under in emerging market debt in hard currencies. We think the growth prospects of emerging economies and fundamentals such as government fiscal balances justify the recent tightening in spreads. In fact, the spread on US credit and emerging market debt is comparable, while we think that the valuation case for US credit is more compelling. In view of the recent strong upward momentum in emerging currencies, we also did not want to be exposed to currency risk. We trimmed our over in US high-yield corporate bonds after spreads narrowed despite worsening fundamentals. We have rotated part of the over into US investment-grade corporate bonds. Emerging bonds risk spreads (basis points) 550 500 450 400 350 300 250 200 12 13 14 15 16 Hard currency Local currency Source: Bloomberg, BNPP IP In commodities we have gone under versus US investment-grade credit. With ample supply and high inventories we think the rally in commodities has been too strong. Moreover, the carry on commodities is significantly negative.
Asset Allocation Monthly April 4 Asset allocation 1 Multi-asset Active s Fixed income Active s Euro Govies Duration Investment grade High yield Emerging market debt Euro Short Dated US Govies Investment Grade (EUR) Investment Grade (US) Real estate Investment Grade (US) Commodities Euro Inflation Linked High Yield (EUR) European large caps Active s High Yield (USD) Emerging Bonds USD Emerging Bonds Local Ccy European small caps US large caps US small caps Japan Emerging markets Foreign exchange AUD CAD Active s Real estate European Real Estate US Real Estate Asian Real Estate Active s CHF DKK EUR GBP HKD JPY NOK KEY Over: Neutral: Under: Increase: No change: Decrease: NZD SEK SGD USD EM FX 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 April 5 Under Changed. have continued to rally, particularly in the US and emerging markets. We think investors are becoming somewhat complacent. More stimulative monetary policy in Europe and Japan may have a diminished impact. In the US, we believe the Federal Reserve is still on course to raise rates later this year. Analysts have cut their earnings forecasts, setting the stage for surprises in the firstquarter reporting season, but we do not see this as particularly positive. In our equity under, we prefer to be under Europe where the positive impact of falling oil prices and a weaker euro should fade and low economic growth and low inflation make it hard for earnings to grow. Small-cap equities: Over Unchanged. The over in European small caps is based on our desynchronised growth scenario: reasonable growth relative to longer-term trends in the US and in the eurozone, but weaker growth in emerging economies. European large caps are significantly exposed to emerging markets, which have hardly recovered so far. Ample liquidity supports small caps and the earnings outlook is favourable, in our view. Government bonds: Neutral duration Unchanged. While recent monetary policy changes have met scepticism in some markets, bond yields fell after the BoJ cut interest rates to negative, the ECB expanded and broadened its stimulus policies and Fed chair Yellen delivered a dovish speech. With major central banks taking this direction and growth and inflation generally low, we are neutral duration in our model portfolio. Only for investors with high fixed-income biases do we recommend taking a short duration position. Investment-grade corporate bonds: Over Changed. We view the macroeconomic fundamentals as positive for this asset class. Defaults are low, credit conditions continue to improve and yields remain historically low in general. In the eurozone we think the carry is too low though to justify an over position. We have rotated part of our over in US high-yield corporate bonds into US investment-grade. High-yield bonds Over Changed. We have trimmed our over in US high-yield. Credit spreads have tightened amid improving US economic indicators, a dovish Fed and a rebound in crude oil prices. Nevertheless, some fundamental factors have deteriorated marginally: downgrades have recently outnumbered upgrades and default rates have increasingly been driven by a pick-up in commodity producer distress. On the plus side, the US economic outlook and monetary policy remain supportive. Slower M&A activity is also positive for bondholders. We still like the carry on these bonds from a risk-return perspective. Emerging market bonds Under Changed. Emerging market growth indicators have hardly picked up and political changes and reforms are making little progress. The rebound in commodity prices has been supportive, but we are concerned that this may have come too early and is overdone. Our cross-asset valuation tools indicate that emerging equities and currencies discount more negativity than bonds. With the upward momentum in currencies we prefer to be under in hard currency debt versus US Treasuries.
Asset Allocation Monthly April 6 Real estate securities: Neutral Unchanged. We are seeing positive real estate fundamentals such as attractive dividend yields, positive supply factors and low funding costs, but high valuations and interest-rate volatility are risks. Commodities Under Changed. While still low, commodity prices have rallied impressively in percentage terms. However, due to the large negative carry, the return on commodities is still negative year-to-date. The combination of a premature rally, given the ample supply and large inventories, and the negative carry has reduced the attractiveness of the asset class, in our view.
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