#Market Strategy — 08.09.2016

Post-Brexit: Has The Lower Volatility This Summer Changed Our Global Economic Scenario?

Florent Brones

Post-Brexit, the financial markets have been less volatile over the summer. Yet we have not changed our investment strategy this month. Several risks remain: a monetary policy tightening in the US, political uncertainty in Europe (Italian referendum, absence of a government in Spain)

Lower volatility in financial markets over the summer…

The main risk before the summer was Brexit. After the vote in favour of Brexit, the markets experienced two days of strong volatility, before calm returned. There was a swift transition between the Cameron government and the new May government and the new Prime Minister highlighted a gradual approach.

In July, there was an improvement in global economic data, while the publication of corporate earnings were in line with expectations.

…but several risks remain

The first risk concerns the US central bank. The Fed stated its intention to raise its key rate in order to pursue its monetary policy normalisation phase begun in 2015. Fed members have a US rate target of 2% for 2 years. The markets do not believe that the Fed will be in a position to raise official rates to this extent.

The Futures on US rates barely anticipate a rate hike (only one!) over the next 12 months. Our scenario is halfway between: we expect 3 rate hikes of 25bp each over the 12 next months, the first in December, and then 2 in 2017. In our view, the market must reprice the US rate curve, which is a substantial risk for risky assets.

In Europe, political risks must not be ignored: the Italian referendum in November and a new government to be formed in Spain. The European banking sector is also facing regulatory uncertainties. China might also disappoint as growth expectations  are high at a time when fiscal policy is already doing a lot.

Nevertheless, we have confidence in the future: the growth and earnings trend is positive.

Divergence of monetary policy

The divergence of monetary policy will be a major theme over the coming months. The Fed will tighten its monetary policy. The timing and extent are debatable, but there is no doubt that it will occur. The other central banks will all contribute to monetary easing over the coming months. The dollar will therefore be strong.

The ECB will probably extend its “Quantitative Easing” programme on 8 September. The same story for the Bank of England which is reacting to  Brexit. The Bank of Japan is considering new measures to counter the strength of the Yen. These measures should be announced on 21 September, the same day as the Fed meeting.

Little change to our global economic scenario

World economic growth should be around 3% in 2016 and 3.3% in 2017. This acceleration in global growth will be mainly driven by emerging markets, while mature economies will pursue moderate (albeit solid) growth. China is an essential driver of this growth, exceeding 6% per annum.

World inflation will reach 4% in 2016 but will slow down slightly to 3.6% in 2017, mainly due to the emerging markets. Inflation remains stable in mature countries.

The search for yield will drive up stock markets

In the medium term, the trend on stock markets will depend on profit and dividend growth, which we expect to remain positive. The main assumption is that the world economy will continue to grow certainly at a moderate (but nonetheless positive) pace. Profit margins (excluding the US) have significant rebound potential, particularly thanks to the oil sector, with the barrel of oil having stabilised at around $50.

In the context of a moderate upward trend in profits and in stock markets, dividends continue to represent a sizeable proportion of total returns from equity investments.

Valuations are not excessive, particularly in view of interest rates which are close to record lows. Equity investments still offer upside potential with a moderate risk, which are two rare characteristics today.