NN IP: Shifting to safer pastures

The uncertainties weighing on the equity market have increased over the past few days. First, the slippery slope towards an outright trade war became steeper with the Trump administration’s announcement of additional tariffs on USD 200 billion of Chinese imports and China’s subsequent retaliation threat. It could all be part of a negotiation strategy, but in the meantime, it hurts risk appetite. 

In addition, a rift has opened in Germany on the immigration theme between Angela Merkel’s CDU and its Bavarian sister party, CSU. There is currently a truce that will last for two weeks, until after the EU summit, during which Merkel needs to find a pan-union solution. This adds another dose of uncertainty to the already fragile political situation in the Eurozone following the populist movement in Italy.

US appears relatively low-risk

We made some shifts in our regional allocation with the aim of reducing its risk profile. We upgraded the US from neutral to a small overweight. Indeed, the US seems to be the region with the fewest issues, at least in a relative sense.

First, emerging markets are coping with a number of headwinds, and these are showing no signs of fading. Federal Reserve expectations keep rising after the somewhat hawkish Federal Open Market Committee decision last Wednesday. Secondly, the oil price is stabilising, but it will depend on the outcome of the OPEC meeting this Friday. A further rise would increase pressure on oil importers and impact inflation (expectations) and government budgets. The strengthening US dollar also remains a headwind for EM. Of course, these three elements are not new, but they come on top of the increasing trade war fears and political uncertainty in several countries. They may start to dent economic data and earnings expectations for EM.

The initial signs of this happening are appearing: EM economic surprises have nosedived, and earnings momentum is negative. For these reasons, but also because of outflows and a maintained overweight positioning, we decided to cut emerging markets to a small underweight according to the Merrill Lynch survey.

Other regions are also coping with challenges. Europe is still seeing some weakness in macro data and uncertain political situations in Italy and Germany. Japan, from its side, is dealing with very low earnings growth (<5%), weak macroeconomic data and Prime Minister Shinzo Abe’s weakened image following some scandals. The latest spike in risk aversion has also led to an appreciation of the Japanese yen, a factor that usually leads to underperformance of Japanese equities. Both the Eurozone and Japan are vulnerable to the increase in trade tensions.

Following these shifts in relative risks, we decided to upgrade US equities from neutral to a small overweight. The region is, in the current environment, a relatively safe haven. Earnings growth is strong, momentum is positive, macro data continues to surprise on the upside, investment flows have turned positive and the underweights are rapidly being unwound.