11 June 2018
Author: Johan Jooste, Chief Investment Officer, Bank of Singapore, Member of OCBC Wealth Panel
This month, we switched our overweight call on European equities to neutral.
We note that its performance has been solid, given the rise in bond yields and positive returns from hedge funds. However, events in Italy have developed such that we consider it prudent to move to a neutral stance for this asset class, and to continue a close watch on developments there.
Italy’s share of the European equity market is on the small side, but it contributes about one third of overall EUR debt issuance, which is obviously very significant. Furthermore, with the political outlook now difficult to forecast, we prefer to wait for more clarity and this could be some months away.
Draw of Europe
Looking at the underlying fundamentals of global equity markets, Europe still looks to be the most interesting from a valuations perspective.
It is trading below other major markets in terms of price-earnings (P/E) ratios, despite having delivered a reasonable set of earnings in Q12018. We are also of the view that the Purchasing Managers’ Index (PMI) points to a strong enough underlying economy capable of sustaining earnings growth in line with or ahead of market expectations.
The rise in U.S. yields has been interrupted by the flight to quality in the days after Italy’s efforts to form a government collapsed. At the same time, market expectations for further Fed hikes have somewhat softened. This is not entirely in line with the underlying pace of improvement still being witnessed in the U.S. economy, and the expectation remains that the gradual drift towards higher U.S. yields will resume. It will take quite a serious global shock for the Fed to alter its course at this point.
In the midst of all this, emerging market (EM) debt has had a poor start to 2018, down nearly 2 per cent year to date. The headwinds of a stronger U.S. Dollar and higher rates may remain for a while, but the underlying credit quality is not a concern at this point, certainly not for our coverage universe.
We re-iterate our view that the best place to be in credit bonds at this juncture is at the shorter-dated end of the spectrum.
Investment snapshot
Here is a snapshot of our investment views for the month:
Europe slowdown continues: Flash PMIs for May point to a continued slowdown in the Eurozone economy. However, business sentiment remains at healthy levels, suggesting fluctuations in the pace of growth, but not a threat to the underlying expansion.
Turned neutral on European equities due to rising Italian political risk: Italy’s new election increases political risk significantly. Italy’s euro exit is not likely but threats will linger. The combination of moderating European growth and rising Italian political risk therefore justify a neutral position in European equities from a tactical asset allocation perspective. Taking a neutral stance on European equities is a risk management call. We suspect the longer-term problems will be contained but in the near term sentiment could turn sour for overall European equities.
Look for shorter duration bonds: In the midst of all this, EM debt has had a poor start to 2018, down nearly 2 per cent year to date. The headwinds of a stronger U.S. Dollar and higher rates may remain for a while, but the underlying credit quality is not a concern at this point, certainly not for our coverage universe. We re-iterate our view that the best place to be in credit bonds at this juncture is at the shorter-dated end of the spectrum.
Still like the EUR/USD: It would be wrong to extrapolate the problems of Argentina and Turkey to other EMs, although stress from the intermittent rise in U.S. yields will likely linger. EM FX sell-off is in the late stage. Generalised pressure should give way to greater differentiation.
Limited upside for oil: We doubt the durability of the OPEC-led supply constraints. As a result of the U.S. shale supply response, we doubt recent price levels can be sustained, and see West Texas Intermediate (WTI) at US$60/bbl over the coming year, with Brent at US$65/bbl in 12 months.
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