13 September 2017
Quarterly Strategic Allocator
The World Grows on an Inextricably Riskier Path
Highlights
¨ Cycle Stage: As the world slowly recovers from the economic and financial crisis of 2008, it also remains in the grip of a political crisis and a largely ignored environmental crisis. More recently, the rise of intangible assets originating from the digital disruption of a technological revolution, combined with the prevailing "low-cost" economic model have durably squashed prices. And the year 2017 has been a confirmation of the economic-recovery-less-inflation story, a recovery notably occurring without the help of long awaited stimulus package, especially in the US. Global economies even appears now to be on a more self-sustainable path despite less accommodative central banks. Looking forward, growth is expected to maintain at a moderate pace in 2018, possibly bolstered by (diluted) fiscal plans. Lastly, as we have been highlighting for over a year, global tensions, unfortunately, greatly impacted markets. This is a risk that is unlikely to recede in the medium term with a non-predictable US international policy. As such, although more favourable than a year ago, the balance of risks still appears titled to the downside in our view with additional concerns stemming from unforeseen spillovers from Chinese deleveraging reforms and mispricing expectations of trade and monetary policies when assets are at historically elevated levels.
¨ Central Bank Stance: As described in the above paragraph, inflation has been on a weak footing and we continue to presume that this ongoing soft trend is consequently likely to persist. While we brought to the fore in our last Strategic Allocator that the current inflation trend is neither a growth nor a labour issue but rather the result of a systemic change, monetary policymakers have yet surprisingly remained silent on the roots of low inflation data only qualified as being transitory. One can argue that fiscal stimulus should push prices up but (i) such plans have yet to materialise in the first place in the context of elevated debt, (ii) the disappearance of manufacturing jobs has been devastating to the working class, and above all (iii) the explosion of technology alongside an "uberisation" phenomenon are furthermore contributing to the disintegration of the economy as it used to be traditionally apprehended and modelled. Then, factoring in the Fed entering unchartered policy territories by reducing its USD4.5trn balance sheet and the next rate hike could be possibly postponed to 2018 alongside the adjustment of the dot plot trajectory. That said, the plan to unwind the balance sheet as we currently know it is designed to have minimal market impacts. In that sense, the FOMC should remain data dependent for any hiking decision. Lastly we can extrapolate from the current resiliency to the US tightening cycle that EM could remain largely immune to future Fed's policies with central banks focusing on onshore factors.
¨ Risk Appetite: Investors have continued to take risk in US equities (S&P500 +9.23% YTD) and EM saw massive inflows into local-currency debt funds against the backdrop of robust fundamentals, managing inflation pressures and a weaker dollar (EM outperformed DM on all asset classes YTD). Yet, the US political confusion in Washington and the test firing of missiles by North Korea with an intensification of warlike rhetoric have strongly buoyed safe havens: Gold +14.25%, JPY +6.42%, CHF +6.20% and TNote10 +2.33% YTD. This volatile situation with repercussions beyond the Korean Peninsula, although intrinsically difficult to predict like any geopolitical risk, is likely to persist which could divert governments from their fiscal objectives by increasing their defence spending instead (South Korea, Japan). Then, although a smooth reduction of the Fed's balance sheet is the base case scenario, great uncertainties surround what is officially called a normalisation process to unwind years of abnormal monetary policies which fabricated a not so normal world. Finally, while removing regulations lauded by central banks might have minimal impacts given their backward looking design, ignoring new and possibly greater threats accumulating just beyond the horizon might be the root of new crisis.
¨ Flows & Technicals: The constructive story towards EM has remained in place throughout the third quarter. While traditional periods of flight-to-quality used to be detrimental to EM assets, this dynamic appears less relevant given the rapid nature of the successions of risk-off/risk-on periods. Benefiting from a Chinese economy bottoming out, Asian economies have constantly improved their fundamentals (steadying growth, adjustment in external deficits) in parallel with a lasting consolidation in commodity prices. Additionally, in the absence of any bullish catalysts for the USD since the greenback is (i) still overvalued by c.10%, (ii) subjected to the Trump-induced pandemonium, and (iii) also depreciating on lower US yields, EM Asia could remain resilient in the wake of an improving CNY sentiment although the risk of a global shift in sentiment remains given the lingering uncertainties underscoring our prudent allocation as described in the next page.
¨ Fixed Income Asset Allocation: Despite an apparent stabilising balance of risks mainly justified by a global economic recovery, too many risks and uncertainties are amassing ahead of us as listed throughout the above paragraphs. We, as such, continue to hold a preference for defensiveness through safe haven and better-rated assets. While major central banks seems to have embarked on a tightening path warranted by an economic recovery underscores our prudent approach towards duration, long opportunities could be sought where monetary policies remain more dovish than anticipated. Lastly, geographically, the US political confusion and Brexit related issues could offer opportunities in Continental Europe and Asia, especially if economic collaboration strengthens between the two blocs (Vietnam/EU FTA, Japan/EU EPA…) with a possible reinforced leadership cooperation.
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