Our monthly market view

July 2018: Balancing act


  • Equities - neutral
  • Fixed Income - neutral

We downgrade equities to neutral

The recovery from April/May in the equity space lost its steam during June, when equities
moved largely in a sideways fashion with some volatility. Again, the markets are
experiencing pressure from the political side; namely, the risk of an escalating trade war.
What started as minor skirmishes has developed into something that could hurt performance
prospects going forward and we see this as a clear risk. In the fixed income space, June was
also a muted affair with most bond classes ending the month slightly on the positive side.
The exception was again Emerging Markets debt, which continued its poor record for the

Going forward, it is not only about trade wars. Although the year so far has produced a
decent return for global equities, the signals are getting increasingly mixed. We see
somewhat weaker momentum on the growth side, political heat is on the rise and very
expansive monetary policy has passed its peak. We do not think the cycle is about to end
yet; however, the pendulum has swung towards a more balanced outlook. Thus, we
downgrade equities and upgrade fixed income – both to neutral. Returns are still to be had,
but to a lesser extent.

Some chinks in the growth armour

The global economy has enjoyed a strong period since the beginning of 2016, and growth
will carry on also going forward. However, we do see weaker momentum compared to a few
months back. The US is still keeping pace, fuelled by tax cuts and an expansionary budget.
But even with its size, it cannot carry the momentum alone. As other regions keep slowing,
the synchronized growth picture we saw in 2017 is fading. Europe is still growing above
potential, but the loss of momentum is concerning. The lingering effects of the euro
strengthening, political woes in Italy (and lately, also in Germany) and the prospect of a
wider trade war are putting pressure on the outlook. Also the Japanese economy has lost
steam lately. Coming from one of the longest growth streaks, it was perhaps not too
surprising to see some moderation.

Emerging Markets, meanwhile, have come under some pressure, with a number of individual
countries experiencing turbulence. The dollar strengthening has exposed weaknesses and
some markets have reacted accordingly. Partly, the political situation has added to the woes
in, for instance, Brazil and Turkey. China is also experiencing some softness, which has led
to easing of both fiscal and monetary policies. Again, we are not predicting an implosion in
growth, but rather highlighting the fact that momentum will not be as strong going forward.

Overall, the growth outlook still supports risky assets, but not to the same extent as
previously. The trade issue is not (yet) eating into global growth, but the risks of an
escalation should not be underestimated. What started as minor tariffs is at the moment
threatening to get worse if Trump gets his way with significantly increasing trade barriers --
not only against China but Europe as well. This is an area we will follow closely. The flip side
is of course the fact that negotiations are most likely taking place and should some kind of
agreement be reached, some of the clouds could disappear and a market melt-up is entirely

Earnings are still a strong support for equities

Global corporate earnings, led by the US, are a bright spot and are likely to reach doubledigit
growth again this year after a stellar performance of over 17% growth in 2017. Like the
economic outlook, the earnings outlook could however begin to diverge further going forward.
US corporations are still on fire, with Q2 shaping up to be another stellar quarter in terms of
both earnings and revenue growth. Europe and Japan will post more modest numbers but
the comparison is somewhat unjustified as US companies are riding the wave of the tax cuts
implemented at the beginning of the year. The trade issue will probably show up in the
earnings numbers, but not during this reporting season. Of course, it will depend on how
future tariffs will be implemented, and by whom, but the fact is that many of the companies
listed, whether in the US, Europe, or Japan, are global. Indeed, the risk is that the second
half of the year could get a little cloudier. Overall, the earnings outlook is still one of the key
positives for equities, providing solid support. Events have to take a serious negative turn for
earnings growth to slip below double-digit growth this year, and at the moment, we do not
see that happening.

We have passed the peak in terms of monetary support

The monetary policy outlook remains relatively benign for the time being, but this is an area
that needs close watching. Only a couple of months ago, inflation was the great scare as the
markets feared it would accelerate during the year, prompting more action than expected
from the central banks. While that prospect has diminished as inflation/wage prints have
stayed relatively muted, it is still on the table. The same goes for rates, which were on an
upward trail together with inflation fears earlier this year. Lately, they have actually fallen
back, and the US 10-year is now back below 3% by some margin. The German 10-year has
also fallen back from the high of around 0.75% to today’s more modest 0.35%. While we still
think the direction is upwards, the process will be slow, especially outside the US.

Central banks slowly tightening the monetary spigots is potentially damaging to the outlook
given some weaker signals from the economy. It could mean less liquidity while at the same
time increasing the supply of bonds (primarily in the US), pushing up yields. This is not yet
the case in Europe, as the ECB will end its QE program at the end of this year. However, the
signal is there and overall monetary policy is tightening. In Emerging Markets, some bias
towards tightening is also present. It is partly because of the dollar strengthening, as some
countries have to defend their currencies, but overall, it adds to the picture of a more
restrictive monetary policy environment. While we do not see the current environment as a
hindrance to the equity market, it could possibly restrict the potential going forward.

Valuations neither a tail- nor a headwind to equities

Equities are still attractive from a valuation perspective, and YTD they have become
“cheaper”. In absolute terms, then, we cannot consider equities expensive, although some
pockets of the global market are a bit stretched. Thus, we still assert that equities can rise at
least in line with earnings growth going forward. 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 very attractive in terms of
risk/return outlook. Bonds have become, on the margin, more attractive after the rise in
yields YTD. We are not overly attracted to bonds, but given the slightly changed outlook, a
neutral recommendation is prudent in our view.

Sentiment somewhat cautious

Equity markets have made a strong comeback after the plunge earlier this year. Likewise,
both sentiment and technical indicators have followed, but the strong conviction is lacking.
The normal pattern of a quick rebound hasn’t occurred and many indicators are tentative at
the moment. Fear-and-greed measures are not showing signs of excessive stress one way
or the other. Technical indicators, such as the RSI, signal some optimism but far from
exuberance. Volatility has behaved quite well after the bouts in February/March. Looking at
positioning, a similar picture emerges. Many investors are still overweight equities but less
so than before. This has been a trend during the year as they have been trimming exposure
to risky assets. We do not see investors fleeing the equity market wholesale, but rather a
continued de-risking of their strategies. In the short end of the markets, speculative
participants are doing the same, although they too are running positive positions. Overall, we
see the sentiment as tentative, for the time being lacking a catalyst. This of course means
that it can go in either direction going forward. Should, for instance, the trade issue get some
kind of solution, we could definitely see markets returning to risk-on mode. Of course, the
opposite applies if events turn the other way.

Trade tops the list of political risks

Around the world, political issues are increasingly having a negative market impact. Starting
with number one, trade, the big risk is an escalation from the current moderate protectionism.
Markets are waking up to the fact that the US Administration is serious in pursuing a
mercantilist trade policy. What started as a minor spat has grown to something more serious
with the heat continuing to turn up. There is of course no way to predict the end game here,
but it is safe to say that trade carries a significant risk to the outlook, not only economically,
but also market wise. Anticipating the moves by the main participants is a bit risky, and
betting on them even riskier. Needless to say, we keep a close eye on this development.

The fuss in Italy has, for the moment, died down somewhat but chances are that it will create
more negative headlines when the new government gets to work. More recently, the unity of
the German governing coalition has been put to question. In short, Europe as a region has
multiple issues to tackle. While any single one might be manageable, put together they could
become a negative. Political risk is back in Europe.

To sum up, while we are not turning negative on the investment outlook, it has become less
attractive. Thus, we lower our long-standing overweight in equities to neutral, notching up
fixed income to the same recommendation. We still see positive returns in the equity space,
but less potential.