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Asset allocation: American vertigo

November’s leading indicators show a fresh short-term acceleration in the world economy beyond the 4% mark. This growth pace is well above potential (3.5%) and should lead to renewed inflation and validate the tougher stance on monetary policy across most developed markets.

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November’s leading indicators show a fresh short-term acceleration in the world economy beyond the 4% mark. This growth pace is well above potential (3.5%) and should lead to renewed inflation and validate the tougher stance on monetary policy across most developed markets. The economists’ consensus is for a gradual normalization in yield curves in the G7 under the cautious leadership of central banks. Against this backdrop, our asset allocation remains resolutely offensive, but includes some selective plays reflecting the highest risks (overvalued markets) and our doubts on the likelihood of a soft landing for global monetary expansion.

It is worth remembering that the strong and synchronized growth we are witnessing worldwide is the result of a successful adjustment by emerging markets after large devaluations in 2014-2015 (external adjustment, then disinflation and interest rate cuts, recovery in consumer spending), Chinese banking stimulus in 2015, reasonable oil prices (US shale) and lastly, monetary abundance from Europe and Japan, which is spilling over into the rest of the world via capital outflows by their institutional investors. Yellen’s Fed has admittedly implemented some faint-hearted monetary tightening, but capital inflows have fueled euphoria on US asset markets (equities, High Yield credit, real estate) to the extent that this has cancelled out the effects of key rate hikes on financial conditions. The strength of the global recovery automatically means a turnaround in all these factors.

The emergence of bubbles (real estate, bonds), which threaten social stability, has already forced China to put the brakes on bank liquidity.

The consequences of this shockwave have rippled out across the entire Pacific Ring of Fire as we expected, with a contraction in the building sector in China, a decline in commodities prices (coal, iron ore, industrial metals), a shift in real estate bubbles in Australia, New Zealand, Canada and the US West coast, and a hit on exports in Peru and Chile. A number of large emergings that seemed to be dragging themselves out of their rut in 2017 could be hit by another recessionary shock due to the drop in commodities prices (Brazil, Indonesia, South Africa). Oil will also act as a recessionary factor for developed countries in 2018 if prices remain above $60 as OPEC hopes.

Lastly, excessive monetary stimulus is almost spent out in Europe and Japan. In the euro area, the ECB is coming close to the issue share limits it set itself to avoid accusations of monetization of public debt. Tapering of the PSPP should come to an end in late 2018 in our view. In Japan, the BoJ’s monetary artillery (qualitative and quantitative easing, negative interest rates and yield curve control) is running up against technical limitations (dryingup of JGB liquidity, lack of equity ETF), the virtual insolvency of regional banks (flat yield curve), the risk of bubbles (commercial real estate) and the likely return to positive core inflation. We expect the 10-year yield target to be raised from 0 to 0.15% in 1H, once US tax reform has been ratified. This will involve a fresh slowdown in JGB purchases by the issuing institution. Synchronized tapering by both the BoJ and the ECB should resteepen the yield curves in the euro area and Japan, with a knockon effect for the US 10-year yield, as the G3 bond markets are inter-connected.

In the US, the stimulus provided by tax reform is set to be drowned out by a rise in inflation, a soaring trade deficit, rate hikes from the Fed and the surge in the dollar. The rise in long-term rates triggered by tapering in Japan and Europe will dent valuations for both equities and real estate. The shock on long-term rates should only be temporary as domestic long-term investors (insurers and pension funds) have already changed their marginal inflows away from equities and into bonds (equity weighting target reached as a result of market rally), and the increase in mortgage rates will soon dry up the source of fixed-rate MBS issues. The combination of high rates and rising budget deficit will particularly accentuate the shortage of dollar-denominated liquidity across the rest of the world, which is already dented by Basel III, with the risk of triggering a short squeeze on emerging markets’ external debt. This US policy mix profile harks back to the Reagan/Volcker era, after which the Third World debt crisis followed hot on the heels.

We maintain our overweight stance on risky assets via equities in the euro area, Japan and emerging Asia, along with European credit (IG and HY) and European peripheral debt, but maintain our underweight position on assets exposed to Chinese real estate risk and the dollar’s rise (emerging debt, Latin-American equities, industrial metals).

Our currency positions (long USD vs. EUR, CHF, AUD) are a telling reflection of our view of a world where the dollar’s exchange rate has superseded the VIX as the synthetic risk aversion indicator.

Raphaël Gallardo , January 2018

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