BNP Paribas AM: US and UK markets overlook

US equities touched further record highs in the first week of October, but elsewhere, equity markets were rather unexciting. Emerging market equities did well, led by Asian stocks. US small caps continued to gain on the back of tax reform talks. Meanwhile, the VIX volatility index held at extremely low levels (see chart). In currencies, the US dollar continued to strengthen slowly, while sterling weakened. Commodities had a mixed week. Crude oil gained on positive news of talks between Saudi Arabia and Russia to strengthen their cooperation to curb global oversupply. However, the gains were wiped out by market concerns over fallout from hurricane Nate which hit the US mainland over the weekend. US Treasury yields rose on the back of positive macroeconomic data. In Europe, the German Bund moved sideways over the week, while Spanish bonds started the week with a rally due to the political unrest in Catalonia before reversing as the mood appeared to become more reasonable and as economic data such as the PMI remained strong.

US: Economy improving on a number of Fronts 

US macroeconomic numbers released this week were on the whole positive. Even though the eagerly awaited monthly non-farm payroll data surprised to the downside with a decrease of 33 000 jobs (this was mainly hurricane-related, with largest drops seen in the leisure and hospitality sectors), market participants focused on other indicators that are pointing to an improving economy and a tightening job market. The U3 Unemployment rate, which stems from the household survey as opposed to non-farm payrolls which are based on a survey of businesses, fell by more than expected, to 4.2%. We believe this number is more relevant since people not at work due to bad weather are not considered jobless (that figure rose to its highest for a September month, at 1.5 million). Average hourly earnings (see chart) – surely the main focus of the employment data – highlighted the tightening of the job market with a strongly positive surprise.

US car sales for September also illustrated the improvement in the US economy. The seasonally adjusted annual rate (SAAR) reached 18.6 million. This partly reflected increased demand to replace damaged vehicles after the recent hurricanes, but it was nevertheless well above market expectations. It was the highest SAAR since July 2005. 

Leading indicators from the Institute of Supply Management also suggested stronger growth. Indeed, the manufacturing purchasing managers’ index soared to its highest since May 2004 at 60.8 compared with forecasts of 58. The report pushed the US dollar higher.

US Dollar: Upside ahead

In our view, the accelerating US economy along with renewed discussions on tax reform should support the US dollar. The currency could also gain once Fed Chair Janet Yellen’s successor is known. The two names that appear to be holding the market’s attention are Jerome Powell, currently a member of the Fed’s board, and former Fed board governor Kevin Warsh. Both appear to favour a more hawkish monetary policy. In our view, Powell is the frontrunner and would be less disruptive from a policy continuity perspective than Warsh, who has been vocally opposed to quantitative easing measures. The appointment may be announced in the coming days. 

ECB policy could also be supportive of the US dollar as a dovish stance weakens the euro. ECB Chief Economist Praet has said "a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to gradually build up and support headline inflation developments in the medium term". According to Praet, the ECB appears to be contemplating cutting its asset purchase programme significantly, but extending its duration.

UK: Further macroeconomic disappointment may halt GBP recovery

Prime Minister Theresa May failed to meet market expectations at her annual Conservative party conference, encountering several mishaps that affected her speech. She struck a reassuring tone on Brexit, but did not present any details, while the UK-EU negotiations on a trade deal are at a standstill. The ruling Conservative party looks more and more divided and there have been calls for the prime minister to resign. We do not expect her to step down as the process to replace her would waste more time in the negotiations, let alone culminate in a risk of a Labour victory should a general election become inevitable.

Recent macroeconomic data has been disappointing. The UK composite PMI rose slightly due to improving services sector figures, but the manufacturing PMI decreased and the construction PMI plunged to 48.1 to a level last seen after last year’s Brexit referendum. Looking at the car market, new vehicle sales decelerated for the 6th month in a row, dropping by a sharp 9.3% in the key month of September and highlighting consumer uncertainties. We are closely watching the macroeconomic data to assess whether the Bank of England will want to remain hawkish in the medium term.

Asset allocation 

Our long IBEX versus MIB trade, illustrating our preference for the Spanish equity market over  the Italian bourse, suffered over the unrest related to Catalonia’s independence bid. We are maintaining our position with our positive outlook supported by upbeat macroeconomic indicators, but we will continue to monitor the political situation.

In currencies, we remain long USD versus EUR. Over the medium to long term, we see the USD strengthening, especially once the Trump administration starts implementing reforms and as the Fed proceeds with its monetary policy normalisation plan.

We are underweight duration, particularly in European bonds, as we expect the ECB to be one of the first major central banks to place greater emphasis on prudent management of financial markets.

On real estate, European stocks have rallied significantly this year, while US real estate has lagged. This encourages us to maintain our overweight in US real estate as we expect this divergence to reverse over the coming months amid a pick-up in demand for US real estate. 

ACTIVE ASSET ALLOCATION STRATEGIES

Short duration

Under our central scenario, expected returns of government bonds are largely flat. However, with our negative equity beta, the short duration position is designed to protect portfolios from an environment of stronger growth and gradual normalisation of monetary policy. This position is also driven by our alternative scenarios. In our upside scenario, where actual growth improves alongside higher trend growth, bond yields would be modestly negative. We give this super ‘goldilocks’ scenario a low probability though.

Overweight US real estate versus government bonds

In real estate, we have rotated our overweight from Europe to the US. In an improving economy with still low rates, European real estate had done well. Since eurozone real estate now looks even more expensive versus its net asset value, we decided to take profits. In the US, valuations look attractive and demand should continue to improve given the robust labour market and other demand indicators. New supply is limited, which should also benefit the asset class. Higher interest rates are a risk, using government bonds a s a funding leg limits the duration risk.

Underweight US high-yield versus cash

High-yield risk spreads have narrowed and a large gap has opened between our macro-based model valuations and actual valuations. Thus, we think that US high-yield corporate bonds are overvalued. Moreover, balance sheets of US companies have worsened. The US corporate sector has increased leverage, causing debts to rise close to record levels relative to GDP. The low level of interest rates is hardly reflected in interest payments relative to cash flow.

Underweight HC EMD versus US Treasuries

We think that at the risk spread on emerging market debt does not properly reflect the challenging outlook for emerging markets. China’s growth may moderate further when support from monetary and fiscal stimulus fades. Commodity prices have rebounded, but are still low from a historical perspective. Leverage in many emerging economies has continued to increase.

Overweight LC EMD versus US Treasuries

We think valuations are more attractive for local currency bonds than for hard currency. Moreover, emerging currencies have shown upward momentum lately, which we expect to continue to support local currency bonds. Falling inflation has enabled central banks in Brazil and Russia to cut interest rates, which should be supportive of local currency bonds in these countries.

Overweight convertibles versus government bonds & equities

We are structurally overweight convertibles for diversification benefits.