Asset allocation in a world of USD strength and low commodity prices

Italian constitutional referendum and European banks weigh on DM stock market but risk premium is back at very high levels for Eurozone equities

The economic fallout from the Brexit vote remains limited, at least so far. Our global composite confidence indicator suggests that global economic activity remains subdued. Looking beyond the short-term, we think the risk of a prolonged period of subdued growth and low interest rates is real against the back of strengthening demographic headwinds and less scope for debt accumulation. There is a growing awareness about the need for more expansive budgetary policies. This could translate in stronger economic activity and higher inflation prints. At the same time, statements remain vague implying that actual implementation might take time. Even with the low level of commodity prices in place, however, base effects will send headline inflation higher in the second half of 2016. Core inflationary pressures look set to remain fairly modest for now, implying that global monetary policy will stay very loose for the time being. This year’s Jackson Hole conference was rather disappointing in the sense that it didn’t deliver much out- of-the-box thinking with regards to monetary policy. Our long-held stance that the consensus view of a continued USD appreciation should not be taken for granted, has been proven right so far. We continue to think that a sharp appreciation from current levels should not be expected. Despite the latest depreciation the USD still looks rather expensive in a long term theoretical perspective. That said, more evidence of the Fed moving towards another rate hike could lead to a slightly stronger USD in the next couple of months.

Asset class to focus on
Euro IG Corporate Bonds
Nominal levels of IG corporate bond yields are at historically low levels. Given our view that default risks will remain contained, thanks to robust fundamentals and low financing rates, our spread tightening bias remains intact.

LC Emerging Market Debt
Risk premiums are still high and investor positioning has some catch-up to do. Certain central banks of EM countries have room to provide monetary stimulus, should circumstances warrant.

Asset class to underweight
Government bonds
The ECB disappointed at its September meeting by not announcing additional stimulus measures. The market (and ourselves) had expected an extension of its asset purchase program. Global growth is set to remain moderate, and inflation is expected to remain below target.

Developed market equities
The Brexit issue has moved to the background given its limited near term impact. However, exit discussions with the EU still have to start and the outcome is still unclear. Political uncertainty remains due also to the Italian constitutional referendum in December. This latter, together with banking sector issues (linked to the flattening of the yield curve), explains the high risk premium for European equity.