31.01.2017

The new (political) deal: buy!

by Oddo BHF Asset Management

Despite some concerns around the start of last year, and the political shocks that unfolded over the course of the past 12 months, 2016 actually turned out to be quite a good year for investors, with most asset classes rising in value. But what can we expect over 2017, and how should investors approach the coming year? In this short outlook document we outline what we expect over the year ahead and set out what we believe could be the best-performing asset classes in each of our main scenarios.

 

Macroeconomics: a slight pick-up in growth looks likely

 

Global growth looks set to accelerate slightly this year. Business confidence improved considerably towards the end of 2016, and there have as yet been no major negative consequences of Brexit. For their part, the markets continue to perform well, with investors viewing Donald Trump as a catalyst for fiscal stimulus and stronger economic growth rather than someone to be too concerned about. Meanwhile, it looks as if interest rates have finally bottomed.

400

Sources: Oddo Meriten AM SAS; Bloomberg Economic Consensus forecast | Data as of 01/03/2017

 

In the US, Donald Trump’s election is expected to lead to a short-term boost to domestic growth thanks to the tax cuts he will put in place for corporates and households. All this is likely to lead to an increase in the Federal budget deficit from 2–3% of GDP to 5–6%. What else could happen early on in the Trump presidency? As well as an improvement in the business climate we expect higher yields and corporate profit repatriation to provide support to the US dollar. Of course, everything depends on the exact nature of the policies he implements when he comes to office, and when he does so: current estimates of the boost to US growth range from 0.3–1.0 percentage points.

But in the medium term, the effect of Trumponomics may be less positive for the US. Protectionist policies and a reduction in trade are likely to reduce its growth potential, while the stronger dollar and higher inflation will hit corporate profits and household spending power. 

For its part, the eurozone looks likely to continue to grow steadily this year, with Germany still leading the way. There are some important positives in Europe, with the credit recovery supporting growth, falling unemployment boosting consumption and the public finances, and budget constraints set to ease this year. However, we do need to bear in mind some risks: there are well-publicised elections in France, Germany and the Netherlands set to take place over the next few months, while the ECB must be careful not to taper its asset purchase programmes too quickly. What’s more, although unemployment is falling, it is still much too high.

400

Source: Oddo Meriten AM SAS, Oddo & Cie. December 2016

Despite its vote for Brexit, we expect the UK to avoid recession. Uncertainty about the UK’s relationship with the rest of the world has resulted in a slump in sterling and pushed long-term rates up. This favours exporters, but is likely to hit private consumption, with consumer price inflation having already risen to 1,6 %. However, monetary easing measures have so far managed to offset the negative effects of Brexit, so we expect GDP growth of around 1.0% this year.

The markets: valuations look fair, but there are pockets of opportunity to exploit

Global equities are not cheap as we enter 2017, but neither are valuations looking stretched. Eurozone, US and emerging equities are all close to their historic average levels, even if emerging equities have derated slightly since Donald Trump’s election.

Company results are finally improving in Europe, where we are currently in the midst of a great rotation from growth into value stocks that started in the aftermath of the Brexit vote. European firms registered their highest EPS growth since Q1 2015 in Q3 last year. Certain areas of the European market, such as automobiles & parts, technology and health care, look to be offering good growth potential at attractive valuations. Insurers and other financial services companies also look attractive, but these are riskier investments. The same applies to banks, which should provide some interesting tactical opportunities for those able to exploit them.

400

Sources: Oddo Meriten SAS, Gavekal/Macrobond, Thomson Reuters. December 2016

 

As to bonds, company credit profiles appear sound in Europe (with the exception of the basic resources sector, which has been hit by lower earnings) and interest rate coverage remains very strong. The ECB continues to provide strong technical support to European investment-grade credit, having bought EUR 46 billion of bonds since the start of its Corporate Sector Purchase Programme. Investment-grade spreads appear fair overall to us at present, whereas the European cross-over market – the intersection between the investment-grade and high-yield universes – looks to have more scope to provide an attractive spread pick-up. Meanwhile, default rates look likely to remain low in both the European and US high-yield markets.

400

Source: Citi as of end of November 2016

Our convictions for 2017: small caps and unconstrained fixed income strategies the best way of capitalising upon higher growth

Our central scenario for 2017, which we assign a 60% probability to, is one of modestly higher global growth. In this scenario we expect to see rate hikes in the US, major political events having only a limited effect on the markets (as was the case in 2016), electoral success for the mainstream candidates in France and Germany – Francois Fillon and Angela Merkel respectively – and the implementation of Trumponomics in the US. Against this backdrop we expect to be:

§overweight US and European equities, European high yield credit and, to a lesser extend, peripheral eurozone sovereign debt
§underweight US and UK sovereign rates and investment-grade credit 

However, a flexible approach that makes use of hedging strategies is likely to be vital for success over the year.

European small caps

The higher domestic growth that we expect to see as part of our core scenario this year could make an allocation to small caps look particularly attractive. US small caps have outperformed US large caps significantly since the US election, and we believe that European small caps may be about to follow suit. European small caps’ EPS growth has lagged that of large caps since 2015, but that might be about to change. What’s more, small cap valuations look very attractive at present – not just relative to their historical average, but also in comparison to large caps. 

400

Source: Oddo Meriten AM SAS. December 2016

Unconstrained fixed income

Investing in the right segment of the fixed income markets at the right time has been vital for bond investors over the past decade, with the best-performing segment one year often the worst performer the next, and major differences in return between the best and worst performers each year.

For investors looking to get the most out of their allocation to bonds an unconstrained strategy able to exploit opportunities across the fixed income universe and quickly adapt its positioning as market conditions change might represent an attractive option. And in a rising-rate environment the ability to hedge credit risk and adopt a negative duration could be instrumental in maximising risk-adjusted returns.

An alternative scenario is one of sluggish growth and higher-than-expected inflation resulting from an increase in wages and / or the oil price. We assign a 30% likelihood to such a scenario. In this kind of environment we would focus our allocation on inflation-linked bonds, alternative strategies and cash.

The final scenario that we could envisage would be of a global slowdown in growth, with consumption and investment down in the US and weaker growth in China, Japan and Europe.  We believe such a scenario is relatively unlikely, with just a 10% chance of occurring. If it did materialise, we would seek to avoid risky assets, overweighting Swiss franc and Japanese yen money markets, volatility strategies and core government bonds instead.

 

 

Nicolas Chaput
Global Chief  Executive Officer & Co-Chief Investment Officer- Oddo Meriten AM
Laurent Denize
Global Co-CIO - Oddo Meriten AM
Gunther Westen
Head of Asset Allocation Germany-Oddo Meriten AM GmbH


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