Recent risk-off moves in equities do not shake our equities conviction…..
Michael Strobaek Global Chief Investment Officer
We see the latest developments as a healthy correction that offers a buying opportunity for clients who wish to deploy cash. Bond yields may move higher yet, but they do not pose a risk to equity markets at this point. USD likely to stay soft given that the macro backdrop remains solid.
Bond and equity markets went into risk-off mode last week. This development was driven mostly by the bond side, with US yields going up meaningfully. In fact, they have already reached our 12-month target of 2.8%, and it was the entire yield curve that moved up.
We suspect yields have moved higher because of a combination of
1) a repricing of Fed fund expectations to the actual Fed forecasts,
2) the strong US labor market and wage data last week, which reinforced this trend,
3) the fiscal consequences of Donald Trump’s tax reform,
4) the very strong US economy that could, if anything, “overheat,” and
5) a general move to somewhat higher yields than what we have seen in the last three years.
The latter may be a reflection of the risk premium on inflation having moved up, which is one reason why we have begun to systematically buy inflation-linked bonds in all mandates. Alternatively, it is a reflection of more optimism about rising US productivity that is mirrored in higher real yields. Yields have scope to move higher in this repricing, but we think the level of around 3.05% will be critical, as this is a longer-term resistance level that has not been broken for many years. If yields do go higher yet, this could become a significant issue for equity markets, and we could see them correct more broadly and deeply. Right here and now, this is not our central case.
A healthy correction
Remember that equity markets were somewhat overbought going into 2018, and were due for a healthy correction, which we think this one is. The move last week was broad-based, and it has brought back a bit of value into a somewhat expensive market. As long as the yield curve moves up in a rather parallel manner (and the front end does not shift too fast), credit spreads do not blow out, and long-term trend lines in equities are not broken, the sort of correction like last week’s is healthy, in our view. We still consider the equity bull market to be intact and to have the potential to go further. Yet, as we have said on numerous occasions, the bull market is not going to be as good as what we saw in 2017, and it will be associated with high levels of volatility, as short rates and now yields have left their bottoms and are moving higher.
However, yields are not yet a threat to equity markets, in particular in the face of the solid economic and earnings growth that we are seeing. So for clients who have cash on the line, we believe the latest developments offer a buying opportunity. Yet clients do need to be patient and take one step at a time. Overall, we retain a positive stance on equities. For clients who are interested in seizing the long-term potential of specific themes such as infrastructure, an aging population and technology, our Supertrends framework offers attractive long-term investment propositions.
USD likely to stay soft
What has been most “puzzling” to many clients is the foreign exchange side, in particular the weakness of the USD. The USD has not been able to rally, despite solid economic data and higher yields. Why is that? First of all, it is perfectly normal for the USD to stay soft in an environment like this, also compared to similar phases in history. The USD tends to become really strong going into “crisis times,” but we are clearly not in such a phase right now. Hence, the USD can likely stay soft, and this is one of the reasons why we have begun to systemati cally hedge our US equity exposure in mandates. However, this hedging is with a five-year horizon in mind. On a tactical horizon, we see the USD becoming somewhat stronger – it appears to have become too weak too fast. However, we do not expect a rapid rise against the CHF, which tends to stay firm in a risk-off environment.
We issued a “warning” in the last IC Report, telling investors to again “protect their gains” either outright or to seek shelter in multi-asset solutions. We still think this is valid, but far less attractive than two weeks ago at the current volatility levels. We also expect that we will finally see a rotation into more defensive and value-oriented stocks (including certain financials), and that the heavy outperformance of technology stocks may be coming to an end. Furthermore, we believe that yields at 3% would be interesting again. Lastly, as long as US yields do not rise significantly above 3%, we believe that the recent developments make emerging market assets attractive. Right here and now, we are comfortable still being positive on equities, and see last week‘s move as a healthy correction more than anything else.