Capitulating on politics?

Politics, policy-mix and financial conditions still dominate the investment environment

Markets have started looking on the bright side of life again after the Dutch elections, if tighter spreads in some European markets are anything to go by. Somewhat paradoxically, yield curves across the world have barely moved in spite of the Fed’s hikes and since Trump election, suggesting markets are not pricing in any acceleration in recovery or central bank movements, in spite of the brightest economic prospects since the Great Financial Crisis.
The main driver of increased appetite may therefore be a perception that political risks have receded, while the good health of the economy still fails to convince markets to embrace a more risk-on mood. The spectre of a possible upset in the French elections may still be weighing on markets, together with Italy complex political situation, or, more subtly, a lack of confidence in the strength of the European recovery.
In this Monthly Investment Strategy, we dig further on the US economic policy landscape, first because the political risks brought about by the French elections has not changed dramatically, and in our view remain limited, and second because as the G20 conference last weekend should remind us, America means business in its desire to change the global trade landscape.
In the communiqué that followed the meeting, G20 members were forced to tweak their traditional sentence espousing the benefits of global trade after the US opposed it. This comes at a time when trade is beginning to accelerate encouragingly after having languished in line with global GDP growth for almost seven years. The tough stance the US has taken with Germany is a warning for the entire EU: The European project should expect less support from the US and instead show that it can grow and consolidate by itself… thus strengthening the case for a positive pro-European agenda.

What has changed over the past month
So what has changed since our last monthly publication? Nothing much apart from the Dutch elections, and the G20. The G20 confirmed the desire of the Trump administration to move with a relatively tough trade agenda. Hence, we focus on the policy risks coming from the US that are set to unfold over the next few months:

• Trade: we expect the US administration to notify rapidly the Mexican government on the revision for the North American Free Trade Agreement (NAFTA). Several options are then possible, including a full repeal, minor amendments, or even an additional Treaty alongside NAFTA. What will matter is really the letter of objectives that will be published later in May or June and will set the tone for negotiations. In our view negotiations on manufactured products make little sense, but there could be more discussion on services1.
• Tax reform: While the scale and scope of the corporate tax reform is yet to be finalised, four key pillars appear to be under consideration with the potential to significantly impact earnings and credit depending on the options (Exhibit 1). Here again, we do not expect clarity for another few months, but in a piece titled “Corporate tax trumpformer”2, we try to shed light on the forthcoming debate. This will guide us in anticipating potential market repricing and in the event, could help understand where and how markets may have been too optimistic.
• Financial deregulation: The next three to four months will see the industry engage with the US administration on the issue. The focus will likely be on smaller financial institutions, freeing credit for households and small and medium size enterprises (SMEs), as well as freeing some bank capital, but we do not expect a large reversal of the Dodd-Franck Act, especially on leverage ratio. Overall, the boost to Financials may also have run its course.
• On the policy mix, central banks have confirmed their normalisation bias, however we have only seen action in the US with the remaining advanced economies doing nothing more than suggesting changes. Yet, it is fair to say that as economies firm across the globe, as trade accelerates, inflation recovers and elections are decided, market appetite for riskier assets might return – albeit without a bang. This is why we have twisted our asset allocation towards more risk, but still holding our breath somewhat until closer to the French elections, as explained below.

Our allocation
Against this backdrop, we have revised our asset allocation to give it a slightly riskier twist. We have upgraded our global equity allocation to neutral after the consolidation seen over the past month. We gradually see more upside potential for Europe than the US, with earnings continuing to improve and potentially surprising to the upside. We also retain our preference for US small caps and emerging Asia. Were political risks to fade in Europe after the French election, some outperformance could occur but it may be a tad too early to position for that.
The rise in long-term interest rates has disappointed so far but we retain a bias for shorter duration for the coming months as we expect rates to inch up along the curve. We see upside in inflation break-evens as the price dynamics solidify in the US and the euro area. More clarity over balance sheet policies in both regions could also lead to more normalisation of the term premium. We also keep a prudent stance vis-à-vis peripheral spreads, vulnerable to both political risk and quantitative easing (QE) tapering.
For the first time in a long time, US high yield showed signs of weakness after jitters on the oil market. However, we have kept our preference for high yield over investment grade, as the environment remains in favour of carry. We have also added carry positions in EM where the softening US dollar could support performance in hard currency and local currency debt.
In currencies, we maintain our bearish bias towards sterling. The economy is softening and the official kick-off of Brexit negotiations will likely unveil the many complexities of the process. A key risk is to what extent the Bank of England (BoE) will be willing to look through inflation and remain on hold.

Laurence Boone – Research & Investment Strategy – AXA Investment Managers