The USD Consolidation, Donald Trump’s Self-Fulfilling Prophecy

,

29 June 2017

Quarterly Strategic Allocator

The USD Consolidation, Donald Trump’s Self-Fulfilling Prophecy

Highlights

¨   Cycle Stage: The scenario that we defined in our annual outlook (“A shallow bond reversal”, 14 December 2016) where we foresaw the 10y US Treasury yield to evolve and to land in the 2.00/2.50% range in 2017 below consensus expectations, the USD strength to moderate before a period of consolidation, alongside arising opportunities for EM is playing out. Against the backdrop of a broad economic recovery, expected to continue albeit at a modest pace, Donald Trump failed to deliver on pledges of already priced-in fiscal policies. As the result the Trumpflation trade has unwound leading to a weaker USD, likely to delight the US President, and lower UST yields, as anticipated in our last Strategic Allocator (“At crossroads”, 31 March 2017). Looking forward, we persist in advocating that US inflation, hence the pace of monetary policy tightening, will mainly depends, again, on Trump’s ability to deliver (a portion of) his stimulus fiscal plans, tentatively in 1H18 ahead of the upcoming midterm election. We anyhow reaffirm our view of soft Trumponomics effects with the possibility for markets to even find relief in a policy status quo while awaiting the next narrative. Additionally, the (geo)political risks and tensions remain high and key market catalysts. Elsewhere in Europe, political risks eased supporting the Euro while the expected stabilisation of the Chinese economy combined with stronger Asian fundamentals and improving regional exports have been positive factors supporting the EM Asia complex.

¨   Central Bank Stance: As we previously alerted on the stabilising/declining inflation prospects, back to pre-election levels, headline inflation is likely to have peaked in 1H17 after a revival ignited by the recovery in commodity prices and a nascent sustainable economic pickup. In parallel, core inflation has also softened. As such, it does not seem to be a growth nor a labour issue since the US is heading towards full employment and other G10 unemployment rates are broadly falling. While central banks explain that inflation merely depending on the labour market through wages will theoretically pick up accordingly sometime, we are cognisant of possible deeper structural changes. Indeed, the explosion of technology alongside globalisation, automation and “uberisation’ may have altered the traditional equation between growth, labour and inflation to the extent of possibly defying current monetary policies. Yet, we note the global resilience of the economy and markets to three well-planned (hence fully priced-in) consecutive rate hikes. Thereafter, the forecasted additional rate hikes (1 more in 2017, 2-3 in 2018) might be delayed should soft economic data prove not to be so transitory, and will also depend on the transition from monetary to fiscal policies. While short term interest rate should remain the key active policy tool, the reduction of the Fed’s balance sheet will be gradual, natural and come with a communication plan in order not to stress financial markets. Despite not committing yet on a timing, Fed’s design revealed in June goes in that direction. Elsewhere, both ECB and BoJ would only start to taper should economic developments warrant it; an apparent nervousness should characterised markets awaiting a communication on QE exit plans although a taper tantrum risk remains low. Finally, most of Asian central banks are expected to remain on a neutral stance for the time being as inflationary pressures appear manageable against the backdrop of a trade normalization in Asia.

¨   Risk Appetite: The strong year-to-date performances of JPY (+4.35%), TNote10 (+1.60%), and Gold (+9.00%) on one side and S&P500 (+8.00%) on the other - as of 28th June 2017 – illustrate that the plethora of optimistic headlines were overshadowed by a lingering risk-off sentiment and that monetary policies remain still accommodative. Furthermore, EM have outperformed their DM peers on all asset classes despite the remanence of risk-off periods and the ongoing US tightening cycle, underscoring our constructive approach on EM Asia. That said, political and geopolitical risks are unlikely to recede in the near future and should continue to impact financial markets although in a milder amplitude since this theme has partially played out. Yet, Donald Trump remains a stress-test to US institutions facing several scandals and probes, and he has yet to define his international policy which is still unpredictable now. This generates confusion and discomfort across the globe and creates an almost inextricable situation as the world is already destabilised by North Korea missile tests, the Middle East crisis (war against terrorist groups in Syria/Iraq, Saudi-led diplomatic confrontation in the GCC countries) affecting Iran and involving Russia looping back to the undefined US policy stance and the ongoing Russia/Trump investigations.

¨   Flows & Technicals: As a translation of the improving sentiment towards EM, foreign investors in 2017 have returned to Asia by re-entering fixed income assets after outflows were recorded in the last part of 2016. The constructive EM story is also reflected in FX markets where all the currencies under our coverage appreciated against the USD in 1H17. Looking forward, we believe that there is further room for EM resilience, in the absence of unforeseen negative catalyst, and as the USD is likely to continue its consolidation being: (i) still overvalued by 12/15%; (ii) exposed to the increasing risks of having no major legislation passed before the 2018 midterm election; (iii) vulnerable to US political turmoil and (iv); correlated to lower US yields. A charting approach also corroborates that the DXY might have peaked in the early days of 2017 and is now consolidating while the UST 10y yield should remain capped below 2.65%, the top of its 30-year descending yield trend.

¨   Fixed Income Asset Allocation: The balance of risks has somewhat improved with the receding risk of a disintegration of the European Union, the confirmation that Brexit is likely to remain a UK-centric theme limiting spillovers, and firming global economic numbers. However, as discussed above, US political risk is high and geopolitical tensions have spread across the globe. We also need to be cognisant of the impact of any economic slowdown and a deterioration in the oil/commodity sector – although not the base case scenario. Lastly, as the Fed is preparing to reduce its balance sheet market participants enter uncharted policy territories; market have been quite muted since the reduction was smaller than previously anticipated. That said, a lagged reaction is still possible once the timing is clarified – a decline in money supply growth would make traditional risk assets the most vulnerable. As such, we maintain our rather defensive stance favouring quality assets.

This message is intended only for the use of the person(s) to whom it is addressed and may contain information that is privileged or otherwise protected from disclosure. If you are not the intended recipient you are hereby notified that any use, review, disclosure or copying of this message and the information it contains is prohibited. If you receive the message in error, please notify the sender by reply e-mail and discard all its contents.   Thank You.