Macro-economic figures are currently strong almost everywhere in the World. The ISM index is back to its local high in the US, PMI indices are also well oriented in Europe, China has stopped being a concern and even Japan’s growth seems to be coming back, albeit slowly.
Micro economic numbers have also been solid since the beginning of the year and for the first time in many years we haven’t seen negative revisions on forward earnings. At the same time, inflation is coming back thanks to a positive base effect with negative impact on rates, which is very positive for banks. Therefore, it seems that being long, what investment banks call the “reflation trade”, still makes sense. However, it may not be that simple.
First, markets seem to be complacent, pricing very low risk even if uncertainty remains quite high in some areas. Since the election of Mr Trump, markets have been booming, expecting tax cuts, infrastructure spending, etc. and all of these measures have been the catalyst of the reflation trade. In short, investors have been counting on “Trump without the bad stuff”. With debt ceiling becoming an issue, and expectations very high, markets might be disappointed on that hand in the coming months.
Secondly, valuations are not very cheap on some specific asset classes. We know that valuations can remain high for a long time and high valuations are not a catalyst for a correction, but on a long-term basis, they reduce the expected returns. US equities seem expensive for instance and some parts of the credit markets are not a bargain.
So how do you position yourself in that environment?
Considering current levels, long-term issues and the positive base effect on inflation starting to fade, we think that US long-term rates could stabilize or decrease over the medium-term. On top of that, real rates are higher is the US than in most other developed countries. With current pricing, there is not a lot a lot of risk in holding 10 to 30 years duration in the US. This analysis does not hold in the Eurozone nor in the UK, with negative real rates and the market pricing very accommodative policies for a long time.
Emerging markets also seem to be a reasonable place to invest currently, both on the equity and fixed income side. The US dollar is quite high versus most currencies and overvalued versus most, meaning that the risk of seeing a major rally in the US dollar, which would be negative for emerging markets, seems to be low. We have also seen negative flows from 2013 to 2015 on this asset class, meaning that investors do not seem to be overly exposed to this area. In addition, valuations on most emerging markets are more interesting than in developed markets (except on the corporate debt side).
European equity markets look also relatively attractive in terms of valuation, positioning, and macro / micro dynamics, and they should reward investors over the medium-term. But here gain, politics might have a negative effect, at least for short periods of times. The French election, potential election in Italy, election in Germany, and discussions about the Brexit… all those events could potentially hurt equities in Europe. That being said, we are still positive on European equities but knowing that we might go through volatile periods.
François Rimeu , March 28
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