August Investment Strategy - Clouds in the US, sunshine in Europe
- In the US, sentiment towards politics and policy has deteriorated as a result of escalating tensions with North Korea and poor cooperation between the White House and Congress. We now expect minimal or no fiscal stimulus.
- We scale down our expectation for further Fed policy normalisation and now expect only three more hikes by end-2018, respectively in December 2017, March and June 2018. Before that, the Fed looks set to announce the unwinding of its balance sheet at its September meeting.
- Poor sentiment in the US and lower Fed funds expectations into 2018 have led us to revise down our targets for long-term interest rates. We now expect 10Y Treasury yields at 2.2% by end-2017 and 2.7% by end-2018.
- In Europe, with economic momentum brisker and inflation on track, the ECB should start tapering from January 2018. However, the strength of the euro will likely weigh on the design of the tapering decision.
While the euro area managed to sustain its upbeat momentum over the summer months, market doubts about the trajectory of the US recovery have started to deepen. As economic growth becomes less dependent on accommodative monetary policy, markets are increasingly focusing on politics and the ability of governments to implement fiscal and structural reforms. On this metric, the euro area, led by two centrist-policy makers with an appetite for reform is faring far better than the US, where to date political manoeuvring has appeared pretty powerless. This has been reflected in the sharp depreciation of the dollar against the euro and other currencies. We do not expect this trend to reverse anytime soon and believe monetary policy is likely to continue to have little role to play. It seems that only a renewed bout of US economic policy action would be able to buck this trend. This environment has profound implications for markets – we now expect little movement in the US curve until year-end, and only very measured ones in Europe, as the European Central Bank (ECB) strives to implement as dovish a tapering pattern as possible, which leads us to believe that equities should fare better in Europe than in the US.
Economic and policy momentum are in Europe
Unusual as it may sound, markets view the economic and policy momentum as more dynamic in Europe than in the US. In regards to the latter, sentiment towards politics and policy has deteriorated. Escalating tensions with North Korea and its weakening relationship with China has led to risk aversion, while poor cooperation between the White House and Congress has raised concerns about the administration’s ability to come to an agreement on tax reform, notwithstanding the debt ceiling and the spending bill issue. In short, US politics is seen as the main source of uncertainty in the Western world and markets increasingly fear that President Donald Trump will head into the mid-term elections with little in the way of policy elements to sell. The risks of a policy mistake have also risen, for example the clumsy handling of Hurricane Harvey’s impact in Texas, could affect the President’s popularity again.
Comparatively, Europe is doing very well. Not only does hard data continue to surprise on the upside, but the outlook appears brighter. The French government looks set to pass labour market reforms without big demonstrations or any social unrest, while Germany will likely re-elect Chancellor Angela Merkel for the fourth time in a row with the only uncertainty being who she will choose to govern with, if needed. Meanwhile, Italy is slowly progressing with its banking sector issues, and has avoided early elections. All this when euro-area growth looks set to be around 2%, with inflation very slowly creeping up, and unemployment returning to below pre-crisis levels.
Against this backdrop, the main issue for the US Federal Reserve (Fed) and the ECB is how to leave the stage quietly, with markets continuing to focus on politics, and how politicians and policymakers will introduce fiscal and structural reforms. This largely explains why Jackson Hole did not provide fresh
information about monetary policy. Fed chairman, Janet Yellen deliberately focused on financial regulation as the various bodies playing a role in this look set to review eight years of post-crisis regulation. Market participants will remember that in the previous run-up to her appointment, she did not campaign, which did not serve her too badly. ECB President, Mario Draghi, in keeping with recent speeches from central bankers calling for more focus on inequality, pleaded governments to continue to pursue globalisation with a special focus on those negatively affected by it. By the same token, this allowed him to avoid mentioning monetary policy or the exchange rate, something which Draghi will most likely address in September or October.
Whether markets interpreted this as a lack of capacity or will from central bankers to act on the exchange rate, in our view the Jackson Hole episode reflected the fact that the euro/dollar fluctuations are largely independent of monetary policy at this stage in the cycle.
Where does that leave us on the macroeconomic and monetary policy fronts?
For the US, we now expect minimal or no fiscal stimulus. Any agreement with Congress will have to comply with the 2018 budget law and would probably consist of only modest tax cuts. If inflation had gained more momentum, this would have led us to revise our forecasts lower by a quarter to half a point, but in spite of wage increases, inflation is still not very brisk. We expect this to change, albeit slowly, over the months to come, thereby slowing growth late in 2018 around 2% for the full year, before falling even lower in 2019. Moreover, as US core inflation has continued to run sideways, with no convincing sign of moving closer to target, it is safe to argue that the fall-back of inflation expectations has been the main driver of the decline in long-term interest rates this year, following the surprising rise last year. In this context, we scale down our expectation for further Fed policy normalisation and now expect only three more hikes in this cycle, in December 2017, March and June 2018. Before that, the Fed looks set to announce the unwinding of its balance sheet at its September meeting.
For Europe, with economic momentum brisker and inflation on track, the ECB should start tapering from January 2018. However, the strength of the euro will likely weigh on the design of the tapering decision. In our view, the ECB will strive to provide the most dovish tapering possible and lead markets to believe it is standing ready on the side-lines, to purchase and expand its balance sheet by as much as necessary, to avoid excessive tightening of financial conditions as the euro remains strong or continues to appreciate. Therefore, in September, we expect no hard decision but the staff forecast is likely to trim inflation projections a little to reflect new FX assumptions. Looking ahead, it is really in October that we expect the ECB to prove creative once again and to deliver tapering while mitigating its hawkish tendencies in order to cap the currency appreciation. In our view, it will play with the many available options, including the timing of the decision, the amount of purchases, the duration commitment of purchases and the forward guidance on short-term interest rates. Changes in the nature of purchases look less likely in our view, given the limited room for manoeuvre under scarcity. Overall, while we expect the October meeting will specify that some tapering will start in the first quarter of 2018, it should leave enough margin for any subsequent uncertainty.
Limited implications for asset allocation
The changes that have evolved slowly since June have had significant implications for interest rates and the dollar but less so for asset allocation at this stage.
Poor sentiment in the US and lower Fed funds expectations into 2018 have led us to revise down our targets for long-term interest rates. We now expect 10Y Treasury yields at 2.2% by end-2017 and 2.7% by end-2018. In 2018, the rise should come from both higher short-term rates and a modest rebound of the term premium as the Fed balance sheet normalises. This should translate to real yields more than break-even inflation. Moreover, the yield pickup in US fixed income compared to the rest of the world has seen foreign appetite resume, both from Europe and Asia. In this context, we see the slope flattening somewhat in coming months, driven by the rise of the short-end of the curve. In Europe, we have maintained our expectations and see Bund yields at 0.6% by end-2017 and 0.9% by end-2018.
As we believe the euro appreciation comes more from policy elements than the differential between US and European monetary policy, we expect it to be somewhat unaffected by the Fed’s shrinking of its balance sheet or ECB tapering, both of which are largely being priced – in by markets. In addition, there will not be the symmetry of the 2014 euro depreciation – at the time, not only did the ECB engage in quantitative easing (QE), but it also brought rates into negative territory, and all in a very weak European environment. Hence we now expect EUR/USD to stabilise around 1.20. Additional appreciation remains a risk as markets despair about Trump’s actions while the ECB would need to engineer a pretty drastic move, for example lowering or signalling possible lower rates again, if it hoped to influence the exchange rate.
In this environment, we maintain our preference for growth-sensitive assets. We especially like European equities over the US but also emerging markets where growth momentum is good and resilience is higher than over the past twenty years. Similarly, carry strategies, especially European high yield, still look attractive despite rich valuations, as the search for yield prevails and the default outlook remains benign. Conversely, we are staying away from core bonds, where we believe prices are expensive and tightening monetary policies will bite on returns.
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