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Focus on Europe
Euro area assets remain a geographical conviction for us. We are now bullish on the EUR in addition to our existing preference for Euro area equities and Developed Market High Yield (HY) bonds (which include Euro area HY bonds). This is consistent with our view that evidence of stronger growth and modestly higher inflation is broadening in Europe. Our preference for Asia ex -Japan equities remains unchanged.
We continue to watch geopolitical risks closely. A largely expected outcome in the first round of the French presidential elections reinforces our view that elections are unlikely to cause lasting market weaknesses in 2017. North Korea poses greater uncertainty, but tensions there have historically weakened markets only temporarily.
US Treasury yields are now near key technical levels. We continue to view the yield pullback as temporary and believe it is an opportunity to prepare for higher yields. In this context, we continue to like senior floating rate loans and US and Euro area HY bonds.
Reflation takes hold more firmly in the Euro area
The Euro area continues to occupy the centre of attention. Regional PMI surveys, retail spending and inflation have held up well. Eurosceptics have also been challenged, first with their loss in Dutch elections and now a likely loss in France. This could mean lesser worries on this front until the Italian elections next year. Unsurprisingly, Euro area assets have done well across the board YTD (see Figure 1 below).
In the US, risky assets continue to await the next catalyst. Corporate tax reforms could be a potential candidate, though Trump’s ability to implement through Congress remains key.
In Asia, the lack of imminent restrictive trade measures and a subdued USD have been very supportive, but tensions regarding North Korea are a risk. Historically, tensions in the Korean peninsula have tended to create excellent buying opportunities, particularly in South Korean equities, but this assumes tensions remain relatively contained.
Figure 1: Reflation broadens in the Euro area
Source: Bloomberg, Standard Chartered 2017 Global Market Outlook
Figure 2: US yields near key technical supports
Source: Bloomberg, Standard Chartered 2017 Global Market Outlook
The Euro area trio
We started 2017 favouring Developed Market (DM) HY bonds (which include HY bonds from the Euro area along with the US). We subsequently added a preference for Euro area equities as we viewed reflation taking a firmer hold in the region. This month, we also turn bullish on the EUR.
As we discussed last month, an increasingly entrenched reflationary environment — increasingly robust survey data, modestly higher inflation (at 1.5%) and improving earnings expectations — has been causing us to turn increasingly positive on Euro area asset classes. This month, the market-friendly outcome of the first round of the French presidential elections, a capped USD and the possibility that we could witness the ECB discuss a scale-back of policy easing sometime later this year mean we also favour being bullish on the EUR.
Turning the focus back to earnings
The macro discussion aside, we believe the focus is likely to return to earnings as a driver of our preferred equity markets. Valuations have already increased across many major regions, which is not unusual at this stage of the cycle. However, at some point, markets will demand to see evidence these positive expectations are justified.
Figure 3: Euro area and Asia ex-Japan equities likely to outperform as earnings expectations get revised upwards
Source: FactSet, Standard Chartered 2017 Global Market Outlook
The positive, and improving, earnings outlook remains a key driver behind our preference for the Euro area and Asia ex-Japan over other regions. Expectations of future earnings are being revised higher across both regions, painting an increasingly optimistic picture. This comes in the context of upside earnings surprises in the US and Europe amid what may be the strongest earnings season in 5-7 years.
Could this picture be derailed by a possible ‘sell-in-May’ seasonal weakness? History is mixed on the consistency of this seasonality; we note that signs indicating a potential correction — such as extreme positioning, sentiment or technical indicators — are still not conclusively in place. While our Group Investment Committee believes there is a 25% chance of a greater-than-3% pullback in global equities, we see a range-bound outcome as far more likely.
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Yields at key technical levels
US Treasury yields declined recently as the rebound in US inflation expectations took a breather. However, yields have already neared key levels (Figure 2) and one-sided positioning in the market appears to have unwound. Both argue yields are likely to rebound higher from here, especially as expectations of Fed hikes in 2017 also rise.
We continue to believe that senior floating rate bonds and US and European HY bonds offer the best opportunity if yields rebound higher. The high yield on offer in HY bonds provides a reasonable buffer against a rise in Treasury yields, while senior floating rate loans offer one of the most direct ways of gaining exposure to rising yields.
Balanced approach edges ahead
Multi-asset income strategies have been one beneficiary of lower bond yields in absolute terms. Having said that, the sharp rebound in equity markets following the French election meant a balanced strategy has also done well.
We continue to expect a multi-asset balanced approach to outperform a multi-asset income strategy. Having said that, we believe the case for positive absolute returns across both remains unchanged and that income strategies continue to be highly relevant for income-oriented investors.
Figure 4: Our Tactical Asset Allocation views (12M) USD
