September Investment Strategy - A political autumn in Europe

September Investment Strategy - A political autumn in Europe

Laurence Boone, AXA Group Chief Economist, Global Head of Multi Asset Client Solutions

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27 September 2017

Economic growth momentum stuck between political and policy uncertainty

In last month's investment strategy, we highlighted how dwindling confidence in US policy-making, coupled with upbeat European growth momentum, had reshaped the market outlook. This month we expect little change in market sentiment, as the focus turns to the upcoming coalition negotiations, following the German election. Overall, we believe markets will continue to look for risky assets, where there are still gains to be reaped, although we would advise caution as risk edges up. In a nutshell, we argue:

  • Global economic growth momentum is upbeat and should continue to lift market expectations.
  • Political uncertainty is preventing any irrational exuberance, with few policy developments in the US, Europe constrained by the German political outlook and little progress on Brexit.
  • On-going monetary policy normalisation is moving at a snail’s pace in the US and the euro area, and as such adds an extra layer of caution on market behaviour.

Growth will continue to lift market appetite for more risky assets

On both sides of the Atlantic, economic activity continues to grow apace. In the US, in the absence of strong policy reform, the economic cycle continues unabated, leading the US Federal Reserve (Fed) to slowly pursue its policy normalisation plan. Looking ahead, fears of secular stagnation should be kept at bay as inflation rises slowly on the back of tighter labour markets and higher energy prices. The succession of hurricanes will only disrupt the quarterly GDP path, and may help trigger additional public spending, albeit we expect, by only a moderate amount. Across the Atlantic, a raft of economic indicators have confirmed the upbeat momentum of the euro area, which is still supported by very accommodative monetary policy as well as neutral fiscal policy, while the exchange rate should remain about stable. Our above-consensus forecast for Eurozone GDP growth suggests there is still some room for more market optimism and therefore risk appetite.

…unabated by muddled political developments

If market participants are looking for sources of volatility, they run the risk of being disappointed by European policymakers, in spite of appearances. The stage may look complicated; there is tension around the Catalonian referendum with the Spanish central government first threatening, and now looking to prevent, the 1 October vote. Additionally, there are the complicated coalition negotiations in Germany to contend with, and their possible implications for European momentum. Yet in our view, provided the Spanish government prevents any violence, risks around the referendum episode should recede. German discussions may last, but we believe they are unlikely to significantly disrupt euro-area economic growth – the main economic effect will likely be a reduction in the capacity to consolidate the EMU framework. However, this should have little impact as long as the growth momentum continues. Only in the case of a resurgence of the euro crisis would we see significant negative consequences, for example if Italian elections turn sour in six months’ time. Not only would there be no euro framework to deal with such a shock, but a ‘Jamaica’ government in Germany, notwithstanding opposition from the nationalist party Alternative für Deutschland (AFD) in the Parliament, would likely struggle to respond appropriately – even more so than during the previous sovereign crisis. One may call markets (or politicians) short-sighted, but investors may benefit in the meantime. Separately, the British vision for Brexit remains blurred, with few consequences beyond local asset, possibly leading to a (small) monetary policy mistake.

… while central banks quietly continue their job

As we have previously highlighted (on many occasions), central banks have continued to carry out their monk-like work in striving to normalize monetary policy, and thus supporting the ongoing momentum with as little disruption as possible. However the recent exception has been the Bank of England (BoE).

As expected, at its September meeting, the Fed announced that it would begin the significant task of unwinding its balance sheet and prepared markets for a December rate hike (now priced at 60%). The balance sheet reduction will kick-off in October, initially at $10bn a month, with the bulk of the activity materialising in 2018. Patient as it is, and helped by the quasi-stabilisation of the exchange rate after a period of appreciation, the European Central Bank (ECB) is gearing-up to cautiously taper its own purchases from 2018, with some (but maybe not all) technical details forecast to be unveiled at its October meeting.

However the exception to this trend is now the BoE, which has strongly indicated that it is preparing to raise interest rates, which markets have priced largely without really understanding the motivation. At its September meeting the BoE surprised markets, and our own expectations, by warning of a tightening in the coming months, and the consensus, like our own forecasts, is now for the Bank to hike interest rates in November. Although the BoE stated this was "the beginning of a progressive monetary tightening", we anticipate that it will be a one-off correction of its politically tainted August 2016 cut….as we struggle to understand the economic reasoning behind the rate hike, when growth slows, inflation is likely to return to target by 2019 and Brexit raises downside risks.

Against this background, we see little reasons to change our asset allocation looking ahead

As expected, and given the above circumstances, appetite for risk remain brisk. Long-term interest rates have bounced back this month in the wake of the improving macro momentum while central banks have reaffirmed their commitment to tighter monetary policy and political risks do not appear acute. Flows continue to fuel the search for yield, while compressing corporate credit and emerging market debt spreads. Although we like equities, as they are generally supported by robust fundamentals, we have concerns around US shares, which again, have recently reached new highs. We are overweight non-US equities and have added some European beta through banks, which will benefit from the rising yield environment, stronger balance sheets and cheap valuations. We remain underweight core government bonds which display very rich valuations and poor expected returns. We also have a positive bias on the USD which may rebound into year end, although the EUR is not our preferred way to play it (CNY, CAD, JPY or GBP look more attractive shorts).

… but we warn about persistent risks

In our view, the main risks are not economics or policy related, but rather political. Thus we have reduced the probability of our « false start » risk scenario from 40% down to 30%, having previously slightly tweaked our baseline scenario for a more modest US GDP growth in 2018-19 and a less ambitious Fed tightening cycle. But we have also introduced a new focus on risk, especially geopolitical. The main risk obviously, albeit less easy to monitor, is North Korea. There, we think the status quo looks the more likely scenario, with renewed economic sanctions but a pursuit of the Korean nuclear programme. Though highly unpredictable, it has the potential to hugely disrupt ongoing momentum and bring us back into a crisis mode, with few policy tools to address the economic consequences.

Download the full slide deck of our September Investment Strategy