FOMC’s Cautious Stance to Support Further Risk Taking

21 June 2016

Strategic Allocator

FOMC’s Cautious Stance to Support Further Risk Taking

Highlights

¨   We reaffirm that the global economy will continue to face tepid and poor growth expectations, with higher risks of disinflation than inflation. In addition, specific pockets of risks include: economic transition in China and economic challenges in LATAM, political noise in UK and Europe, the upcoming US presidential election, and geopolitical tensions coupled with the worldwide spread of terrorism. However, recent market developments have given us some reasons for hopes translating into risk-taking, explained mainly by a softer pace of US rate normalisation rather than a brisk economic recovery, alongside a broad commodity price bullish reversal. This has yet to be balanced with any aggravated factors mentioned above which could translate into exacerbated volatility and surrendering markets. We believe this will remain the investing essence for the remainder of 2016 with specific region and asset classes likely continue to attract capital for opportunities. Lastly, to tackle the fear of a recession looming in 2017, we presume that monetary policymakers will at least be accommodative if not innovative, especially in an event of a premature failure of NIRP in Japan and/or Europe.

¨   Despite growing scepticism over their monetary policies, we assume that Central banks will remain key economic agents and price makers. Central Banks can be segmented into three categories depending on the degree of “ammunition” left: (i) those with limited further solution due to the extensive use of QE and rate cuts which appear now constrained – BoJ, ECB, SNB, and Riksbank; (ii) those where unconventional policies have not yet been implemented with further room to ease – BoC, RBA, RBNZ and Norges Bank; and (iii) those on the way to normalisation reversing from QE – US Fed and BoE. As a result, the wider the scope of intervention tools, the greater the perspective of positive consequences on the economy will be. While BoJ and ECB seem to be committed in time to assess effectiveness of NIRP, the way to economic recovery hence normalisation in the US is still a bumpy road and markets pricing indicates only one US rate hike for the rest of 2016. 

¨   The first part of the year has seen a combination of risk-on/risk-off scenarios when a prudent change of stance from the Fed alleviated fears of tightening, prompting gains to risk markets while investors have remained wary of adverse factors as safe haven assets have performed well. In line with our previous reports and since we believe little has changed, we expect risk takers to increase their positioning towards commodity linked assets which should tactically outperform and positively impact the EM space. Additionally, with most DM rates to remain low - in our view, 10 year US Treasuries should range below 2.00% and above 1.50% - HY would gain momentum on the carry trade and, given the current economic phase, safer assets will remain in focus to ward off event risks.

¨   After capital flight in 2015, flows for EM in 1H16 have coincidentally reversed to positive from negative on the US Fed dot plot downward revision in March. This supports our thesis and illustrates the changing risk appetite. Furthermore, in parallel to oil prices bottoming out, inflows spread into commodities: energy, agriculture, currently reversing for industrial metals, and in particular Gold, the top performer in terms of flows YTD which on the contrary was one of the worst performers last year. On the hand, flows into Equities and DM have remained strong, bolstering our risk-on/risk-off scenario. Finally, our technicals also advocate for EM Asian and Commodity currencies resiliency, if not outperformance driving the hunt for higher yields in a risk-controlled trade-off.