#Investments — 11.09.2017

Economic background to our investment themes

Guy Ertz

A Goldilocks environment.

All the key leading indicators point to a broad-based economic expansion without inflationary pressures that would force central banks to act swiftly to remove accommodation.

Best positioned growth drivers are consumer spending, thanks to declining unemployment and better wage trends, and investment spending, thanks to solid profitability trends.

Close scrutiny of leading indicators shows that developed countries are on more solid foundations than emerging countries. This is most explicit by looking at the emerging countries’ manufacturing PMI excluding China, Korea and Taiwan. This indicator falls below the critical 50 line which is supposed to separate expansion periods from contraction periods.

None of the major central banks needs to correct existing policies fast, which supports the longevity of the current economic cycle.

Start taking profits on corporate high yield bonds

High Yield Corporate bonds have performed extremely well in recent years (see chart). The improvement in the economic data and in corporate balance sheets supported by very low yields has led to a demand for those bonds. This has also led to a sharp fall in the risk premium for corporate bonds (as measured by the difference in yields between government and corporate bonds).

We are approaching the end of the credit cycle as we see companies starting to increase debt relative to their earnings. The expected rise in bond yields suggest more caution especially in the US.

Investors who accumulated large positions of high yield bonds should start decreasing their exposure especially for US high yield. Attractive opportunities exist either in equities, and alternative Newcits.

Equities: Still the asset class of choice

What does usually end a bull market? Recessions (8 times out of 10 since 1926) or extreme valuations (twice: the Cuban missile crisis in 1962 and the 1987 flash crash).

Today, we do not see a recession on the horizon. Valuations are admittedly elevated but are justified by low rates/yields. Fundamentals point to the continuation of a primary uptrend within the next 6-12 months. Geopolitics is the main risk in coming months.

We remain bulls over the medium term. There is a promising 12-month outlook based on high single-digit earnings growth prospects. In addition, over time, valuations will become even more stretched as longtime cautious investors finally throw in the towel. We retain our preference for the pro-cyclical markets, i.e. the euro area and Japan.

We like the euro area. It has an earnings catch-up potential that is finally turning real; support also comes from share buybacks, M&A activity, returning foreign inflows. Valuations are attractive, among others with a 3% dividend yield.

 We like Japan. It has solid fundamentals (domestic demand is the driver and deflation is finally left behind). It enjoys the best trend in earnings revisions among main countries. It is THE market that benefits from rising US bond yields. Help should come from an expected weakening of the yen. Finally, valuations are attractive.

Good value in value investing

All the factors are in place for outperformance…

We expect rising bond yields. This is a prerequisite for value stocks to outperform. Correlation is tight as both depend on an improving economic background, which is our central scenario for 2018.

…and valuations are supportive

On a price-to-book basis, value stocks trade at a 55% discount to growth stocks versus a long-term average discount of 48%. Value stocks will generate faster EPS growth as they are more sensitive to the economy, which will support their PEs. The dividend yield is considerably higher than for growth stocks.

Remain reasonable with regards to the outperformance potential

The rise we expect in bond yields is limited. Hence, outperformance potential will be reined in. It is nevertheless present and should become the most significant when investor risk aversion recedes in the face of continuously positive macro data.

Opportunities in alternative UCITS

Government Bond yields and credit spreads remain at low levels and in some cases close to record lows. This is a challenge for investors as it suggests that expected returns for bonds are very low.

We see opportunities in “Alternative UCITS funds” mainly in the areas of “Event Driven”, “Long-short equity ” and “macro” strategies as they offer an attractive risk return trade-off while limiting the sensitiveness to a rise in interest rates (also called “duration”).

Volatility levels are very low and should increase. This should support UCITs strategies.

Upside for the dollar over the coming months

The dollar weakness has been a key theme over recent weeks. Given the US mid-term elections in November next year, the Republican party is expected to be gathering around the president to deliver policy measures (tax and deregulations) over the coming weeks to make sure to deliver positive economic developments by spring time next year.

Given that assumption, we think that the markets are underestimating what the Fed will do in terms of policy normalisation while the opposite is true for the ECB outlook. The interest rate differential should move in favor of the dollar again. This supports the view that the dollar should be making a gradual come-back.

Technical factors suggest that we could see the euro fall back to the 50-day moving average at around 1,15 over the coming weeks.

We have a 3-month target at 1.13 and 1.10 at a 12-month horizon.