June Investment Strategy: This war talk’s spoiling all the fun
- The US economy is still strong, whereas the Eurozone shows weakening signs
- Yet, the Federal Reserve is increasingly dovish, a by-product of the US administration’s trade hawkishness, whilst the European Central Bank is failing to convince markets that it can deliver accommodation
- All eyes are now on the US/China conflict with hopes (we share) of a truce
- Yet, the damage – through tighter financial conditions and unrealistic easing demands – may have already been done
- We maintain a limited risk appetite with an underweight in European equities, and an overweight in emerging market debt and US high yield credit
It’s still all about politics
Market gyrations and the fate of the global cycle remain utterly dependent on political noise. There is still little clarity on the trade war(s), and as such the focus is now firmly on the G20 meeting on 28-29 June, but it may not be a big binary event. We could end up with no escalation on tariffs… but still no comprehensive deal between China and the US. We suspect we will have to cope with a continuous stream of skirmishes and flare-ups, especially as the 2020 US presidential race starts in earnest, thus eroding global confidence. The same applies to Brexit. The long extension granted to the UK was expected to bring a measure of peace and quiet. Instead it has offered a window for a Tory leadership challenge which is reviving concerns over a no-deal exit.
The European elections were a collective victory for mainstream parties, undermining the populists’ claim they were on the brink of sending the Union on a completely different path. But uncertainty has not disappeared. The discussion between Rome and Brussels on fiscal policy is getting fraught again. The initiative on a Euro area budget is very limited in scope. The mainstream has won but it is unclear what it wants to achieve on solidifying the monetary union.
Dovish Fed: It’s not the economy, stupid
The US economy is posting a few signs of slowdown at present. Job creations slowed to 75,000 in May but printed at 150,000 on average over three months – weaker than in the past few years, but enough to absorb labour supply growth and stabilise unemployment at its record 50-year low. Other labour market metrics remain solid. The manufacturing ISM survey has stabilised, but the Empire State survey fell precipitously in June, likely reflecting heightened trade tensions with Mexico. Consumer confidence and non-manufacturing indicators remain relatively upbeat and consumer spending appears to have firmed after a weak start to the year. Altogether, we still forecast above-potential US growth in the second quarter of 2% and expansion of 2.4% in 2019.
The Federal Reserve (Fed)’s dovishness stems more from global crosscurrents and the risk of further trade-related tightening in financial conditions. In previous research, we have illustrated that economic data may not reflect a pernicious downturn for several months after signals from financial markets. Hence, the signal sent by the inversion of the US treasury yield curve – a causal trigger for US recessions rather than a mere market indicator – should not be dismissed quickly. The US/China trade negotiations will be key. In our baseline, we expect neither an escalation (all Chinese exports to the US tariffed at 25%) nor a final deal (the conflict has spilled over into a tech war) but rather a truce similar to that offered to the European auto sector. Still, even in this relatively benign kicking-the-can-down-the-road outcome, we expect the Fed to ease policy, most likely cutting interest rates in September and December to offset the past tightening of financial conditions. Indeed, the impact of the trade war is not solely on exports and imports of goods, their prices, nor inflation eroding households’ purchasing power and corporates’ margins. The first-round effect takes its toll through confidence and deferred capital expenditure.
The next step in European Japanification
Meanwhile, European macroeconomic data flow has been disappointing. Manufacturing business surveys have merely stabilised around six-year lows, often dragged down by forward-looking components. German manufacturing orders posted their worst performance in 10 years, suggesting that the first quarter (Q1)’s economic rebound has been short-lived. True, the domestic-oriented services sector, consumer sentiment, job creations and hiring intentions have remained at still solid levels, at odds with the manufacturing gloom. But clouds are gathering also over European domestic demand.
With core inflation stubbornly stable around 1% for more than two years now, the Eurozone macroeconomic outlook and global trends that worry the Fed also concern the European Central Bank (ECB). At its June meeting, the ECB attempted to defend the case for a still ample monetary toolbox. With 15 more years of experience, the Bank of Japan (BoJ) offers an obvious benchmark and has similarly been repeatedly arguing – and again this week – that further accommodation was possible if needed. Markets were first sceptical (with lower interest rates but with little actual easing seeing real rates almost unchanged) but bought into President Draghi’s extreme commitment at Sintra, sending 10Y Bund yields below -0.3%, a new record low.
Asset Allocation: Preference for credit vs. equities
June has been kinder to risk assets, thanks to rising dovish expectations which were compounded by Mario Draghi’s speech at Sintra on 18 June. Equities appreciated and credit spreads tightened as a result, while interests rates remained floored at levels last seen in 2017 (US Treasuries at 2.10%) or below (Bunds at -0.25%). Low growth and inflation mean (more) accommodative central banks and that feeds the hunt for yield. This is a favourable environment for credit markets, but less so for equities, which have lost some of their lustre since late April. While equity investors will be waiting for signs of an earnings’ reflation, credit investors will be encouraged by benign conditions to refinance and repay bonds.
Looking ahead, we remain prudent on developed market equities, given that risks have increased around the trade negotiations. We remain constructive on higher beta spread products that tend to benefit from central bank accommodation. We maintain euro core government bonds at neutral as lower growth and falling inflation should cap yields. In a nutshell, our key positioning is underweight European equites and overweight emerging market debt and US high yield (HY) credit.
From a tactical standpoint we are alert to the risk of a mini rates tantrum, in which rates could jump higher whilst risk assets could likely sell off simultaneously. This could be triggered by a detente between the US and Chinese Presidents at the G20 Summit, which could force markets to reprice their strong expectations of Fed rate cuts.
 Page, D., “Rising trade tensions weigh on Fed outlook”, AXA IM Research, 13 June 2019
 Page, D., Venizelos, G. and Savage, J., “Is the yield curve pointing to recession?”, AXA IM Research, 25 October 2018
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