Our monthly market view

April 2018: Battle between fear and greed


  • Equities - overweight
  • Fixed Income - underweight

Trade jitters aside, we still see the best potential in equities

Markets continued their bumpy ride in March, following on from a volatile February. A partial
comeback and rebound in markets in the earlier part of the month gave way to a relapse, into
the more fear-driven environment seen a month ago. Trade moved centre stage as President
Trump moved to carry out one of the cornerstones of his campaign, namely a pivot towards
protectionism. And part of this pivot includes reducing the substantial trade deficit the US is
currently running (and has been running for a long time), particularly vis-a-vis China.

With tensions running high in the markets, the obvious question is if this is the beginning of a
longer downturn. We do not think so. Although rising protectionism has the potential to cause
some damage, things have to escalate quite far from today for that to happen. The value lost
in markets over the last month by far outstrips the actual impacts on economic growth of the
tariffs introduced so far, which have been very limited, while a major escalation also appears
unlikely. And this brings us to our stance for the coming months: we still see potential in risk
assets on the back of continued global growth and stellar earnings. Headlines will continue to
flare up, but the underlying fundamental picture points to further gains in equities over fixed
income. Hence, we still recommend an overweight in equities.

Robust growth ahead

Recent data have continued to provide further evidence of a global economy firing on all
cylinders. Despite some disappointments vis-à-vis increasingly optimistic expectations, the
level of the figures suggests a further acceleration in growth versus last year. We do note that
expectations cannot go higher indefinitely, and that we will probably see some roll-over going
forward but this is far from a signal that things will go materially south in the global economy.
Moreover, growth looks ever more broad-based, with most areas of the global economy
contributing. The US economy, for example, will be supported by both pent-up demand for
investments and the boost to the overall economy from the Republicans’ tax reform in addition
to the new budget package, which adds additional spending to an already booming economy.
Meanwhile, the Eurozone and Japan continue to show above-potential expansion, ensuring
the overall picture in developed economies remains promising. However, the latter two regions
look to be plateauing, but at current levels it is hard to be disappointed with the economic

Emerging countries have also, by and large, provided markets with positive data. China has
continued to produce impressive growth figures, despite some weakness in, for example, the
housing sector. A controlled slowdown there should, however, be welcomed as part of the
Chinese economy’s needed ‘rebalancing’. In addition, Eastern Europe and Brazil remain on
the right track, exhibiting accelerating growth, although the steepest rises are likely behind us.
India, on the other hand, has disappointed somewhat of late, but as the reform drive continues,
growth should pick up again. From an investor’s viewpoint, then, the global economy continues
to steam ahead in a particularly synchronised manner. Nevertheless, the risk of an escalation
of trade frictions has the potential to cause some negative effects, but we are looking at very
minor consequences, at least judging by the magnitude of the actions taken so far. Moreover,
it is becoming increasingly clear that Washington is using tariffs as part of a negotiating
strategy, whereby it wants to ‘start big’, create headlines, but then subsequently row back
whilst still achieving some concessions. The case in point in this regard was the recent steel
and aluminium tariff announcement, which was subsequently watered down substantially from
the initial proposal.

Earnings are on fire

As the global economy motors on, so do corporate earnings, which are likely to reach double digit growth again this year after a stellar performance of close to 17 percent in 2017. However,
the drivers of this year’s strength will have to be somewhat different from last year, as the
flattering base effects in commodities continue to fade. In fact, we will have to increasingly rely
on the continued strength of the global economy. And with growth estimates continuing to
edge higher, we can indeed put some confidence in this. Judging by the reporting in Q4,
companies are more upbeat in their guidance for 2018 than they have been in a long time. As
the macroeconomic backdrop continues to improve, we can expect continued improvements
on the revenue side, whereas costs are likely to remain broadly in check. On top, the US tax
cuts have provided a single-handed boost to global earnings of close to five percent. Q1 is
shaping up to be another very strong quarter, although we do see some weakness in Europe
and maybe Japan. The former region is hampered by a strong currency and a lack of IT
exposure. Revision trends are also somewhat weak in both Europe and Japan. Still, 2018 is
on track to register yet another year of double-digit earnings growth. Overall, then, corporate
earnings will remain a firm support for equities going forward and thus a cornerstone for our
continued overweight.

Central banks to wean markets off stimulus slowly but surely

The monetary policy outlook remains relatively benign for the time being, but this is an area
that needs close watching. Even though we see the correction during February as technical,
some of the origins could be traced to the inflation outlook and thereby also potential central
bank policy adjustments.

There are signs that inflation, primarily in the US, is showing signs of life, although we would
not base our view on a single wage growth print. However, markets are factoring in the
possibility, with some of the recent move in the long end of the US curve is due to worries of
higher inflation going forward. A certain amount of repricing of the Federal Reserve’s future
rate hikes has accordingly taken place, taking the markets closer to the Fed’s own curve. The
ubiquitous debate around exactly where higher yields start to hurt the equity markets is alive
and well, and our view is that the market can handle more than the current level on the 10-
year yield (at the time of writing, around 2.8 %).

It is, however, a complicated relationship as three considerations must be put into the equation,
namely the speed, magnitude and reason of higher yields. It goes without saying that sharply
higher inflation numbers, accompanied by higher yields, is more damaging than a slow
grinding upwards on the back of a steadily performing economy. In the latter case, a level
around 3.5 % would not be a problem in our book, while if this move were to materialise rapidly,
it would be. As stated above, this part of the market needs an extra amount of attention going
forward and is one of the key risks for the coming year. In our base case, though, the 3.5 %
level is unlikely to be reached in the short-term and hence is unlikely to derail equities.
In Europe, the European Central Bank (ECB) is likely to continue tapering its asset purchase
programme, while interest rate increases are still in the distant horizon. This, like the Fed’s
tightening, is unlikely to prove a problem for risky assets, unless an unexpected pickup in
inflation clouds the outlook.

In the emerging countries, monetary policy is still on the ‘easy’ side of the spectrum. Asian
central banks are, on balance, on hold, with the Chinese authorities tightening regulation and
thereby also financial conditions, and at the same time adjusting reserve ratios in order to
increase liquidity. In the majority of the remaining emerging economies, easing cycles are also
nearing an end, although low inflation in the likes of Brazil and Russia does provide further
room to ease policy.

While still a benign environment in terms of monetary policy, the golden days of (almost)
unlimited stimulus is over. The path towards policy normalisation is underway, and we expect
a gradual tightening going forward. But as long as that path is guided by continued growth
without inflation taking off, it should not be enough to derail further advances in the equity

Valuations should not prove a hindrance to equities

Broadly speaking, global equities are still fairly priced. One could almost say that equities are
slightly more attractive after the correction, as valuations have taken a small hit. Going forward,
valuation by itself is unlikely to hinder equities. There are, however, pockets of stretched
valuation, such as US equities and some sectors such as Consumer Staples, meaning in some markets downside buffers are exceedingly thin. Nevertheless, on the global aggregate level
stocks are not especially expensive. Thus, we still assert that equities can rise at least in line
with earnings growth in the foreseeable future. Earnings growth will have to do the heavy lifting
but given our expectation of continued earnings and margin expansion globally, valuation may
well edge slightly higher. Given that most risky bonds are yielding very little in excess of
government securities in historical comparison, and riskless rates still hover near record lows
with risks tilted to the upside, equities remain unmatched in terms of risk/return outlook. Bonds
have become, on the margin, more attractive after the rise in yields YTD, but far from enough
to make us change our stance on fixed income.

Sentiment a diverging story

Sentiment has indeed been on a wild ride since January. After the February scare, sentiment
began to recover during the early stages of March but relapsed heavily after trade concerns
made the headlines. At the time of writing, fear is dominating the mood in the investment
community. To us, this shows the nervousness within markets after the start of the year. Many
technical indicators have thus fallen back and show less of an extended environment.
However, while fear might be the word in vogue, positioning seems to tell a slightly different
story. Investors are still long risk, and judging by that, not wholly convinced that the time to
make an exit is upon us. TINA (=There Is No Alternative) is obviously not dead. If this narrative
would be losing steam, it would definitely be showing up in both allocations but also flows.
These have been lacking somewhat but we are not seeing any exodus from equities. Cash
levels still are a bit high given the stage of the cycle; however, that has been the case for quite
some time now. The underlying optimism is relatively intact, which is not surprising to us;
fundamentals still favour risk-taking. As short-term sentiment clearly has the ability to influence
markets, we keep close tabs on this area. Since the optimism is still widespread, despite short-
term headwinds, the risk going forward is that markets again grow too complacent. Right now,
they are reluctantly positive.

On the political front, Trump and trade in the limelight

Politics will always be a part of markets, but for now, risks remain relatively well contained. In
Europe, political risk has decreased since last year’s election in France, although we will
always have something to focus on in this region. For example, Brexit negotiations will
continue to grab headlines going forward, while there will also be focus on Italy’s potential new
government, but overall, the impact from politics will be less than in the last couple of years.

Geopolitically, the usual risks still apply. The North Korea situation, however, appears to have
turned for the better; an unprecedented meeting between Kim Jong-Un and Trump is set for
May. Probably, meeting or not, we have not seen the last from this particular part of the
geopolitical puzzle, but these developments are encouraging and lessen one of the major
market risks. Meanwhile, turmoil in the Middle East is ever-continuing, and is at risk of
deteriorating with the appointments of Mike Pompeo as Secretary of State and John Bolton
as the new National Security Advisor to Trump. Both are hawks on Iran, and should the “Iran
deal”, struck under the Obama administration come under pressure, the situation could get
more tense. However, the Middle East is more about headlines than actual impact on markets,
but the one direct area it can have an influence on is the price of oil, where indeed a
geopolitical premium is increasingly being factored in.

The main worry, however, is of course the risk of an escalation of the trade issue, instigated
by Trump at the beginning of 2018. What started with washing machines and solar panels has
become something larger and the markets are worrying about further knock-on effects if US
trade partners start to retaliate. So far, however, the market value lost in the equity markets
due to these worries has by far outgrown the estimated economic effects from the tariffs:
trillions of dollars have been lost in global stock markets the last couple of weeks, while
Trump’s latest suggestion is 25 % tariffs on goods from China of up to 60 billion dollars. This
whole situation is of course worrying, but given how the previous proposals have been watered
down before implementation, it could well be an over-reaction from markets. Again, look at
what Trump does, not what he says.

In conclusion, then, the investment outlook is still supportive for risk-taking, despite the latest
nervousness around potential trade wars. We remain in something of a sweet spot for risky
assets, marked by broad-based and resilient economic growth, strong corporate earnings as
well as largely benign monetary policy dynamics. We continue to favour equities over fixed