AXA IM's macroeconomics and asset allocation convictions for June 2019

Risks are rising this month

Laurent Clavel and Serge Pizem discuss their macroeconomic and asset allocation convictions for June 2019.

According to Laurent Clavel, Head of Research at AXA Investment Managers: “After months of positive headlines, the latest step-up in US protectionism comes as a bad surprise for economists and markets”.

• The European elections expectedly produced high political fragmentation and have interesting domestic and regional implications.
• US-China tensions are back with a new round of tariff increases and threats of further escalation.
• First quarter GDP data surprised on the upside in the US (significantly), in China and in Europe.
• The demand breakdown as well as latest Chinese activity data and global business surveys confirm the fragility of the ongoing recovery to adverse shocks.

“Politics is worth following in Europe. This is not because populists expectedly rose strongly at the 23-26 May European Parliament elections. Indeed, despite Italy’s Deputy Prime Minister Matteo Salvini’s best efforts, the alliance of Eurosceptic parties is fraught with divergences and has fallen short of a majority (the improbable combination of the three far-right European groups do not even match the right-wing EPP). Beyond the upside surprise of a 20-year high turnout, these elections mainly confirm the European political fragmentation. These elections are also important in terms of domestic political implications (“European Parliament elections: More noise but some signals”, AXA IM Research). The results especially put at risk the stability of the government coalitions in Italy and Germany. We will also wait for the subsequent round of top appointments, especially at the European Central Bank with President Mario Draghi and Executive Board member Benoît Coeuré leaving by year-end.

“On the trade war side, after months of relatively positive US-China “negotiations progressing well” headlines, the latest step-up in US protectionism with President Donald Trump announcing an increase in tariffs from 10% to 25% on $200bn of US imports from China and threatened a further 25% on the remaining $300bn, comes as a bad surprise for financial markets – which went into risk-off mode – and most observers.

“Why this setback? First, we recognise that US policymakers and White House trade policy has swung sharply in recent months. Second, the US-China confrontation goes much deeper than trade and, while we still expect a trade deal to be reached over the summer in our baseline scenario, we characterise this as an extended truce rather than permanent peace. Third, and most importantly for financial markets, President Trump may be counting on a US Federal Reserve (Fed) bail-out; a sort of “Too Crazy to Fail” policy. Since its December communication mistake (not a policy one in our view), the Fed has been shifting tone and forward guidance (the ‘dots’), clearly reducing its previous hawkishness. This policy stance shift to date is an adequate reaction to the tightening of financial conditions, but it also affects President Trump’s best alternative to a negotiated agreement, offering the White House room for a more hawkish trade policy.

“This new round of tariffs comes at a time when our hopes of a swift cyclical recovery were beginning to be confirmed. US GDP accelerated to 3.2% (annualised) in the first quarter (Q1), surprising on the upside. And even if erratic, short-term factors boosted the start of the year, we still see Q2 growth holding up at 2.0%, above trend, while the US unemployment rate is already at a 50-year low.

“In the Eurozone as well, Q1 GDP growth was higher than expected across almost all major countries, at 1.6% (qoq annualised) after a worrying 0.9% in Q4 2018. This upside surprise may, however, be short-lived seeing manufacturing business surveys: German orders for example recorded their worst performance in a decade. Hence our careful upgrade of our eurozone growth forecast for 2019, up 0.1 percentage point to 1.1% with risks, in our view, skewed to the downside.

“In Asia, the latest batch of monthly data has been mixed: China’s activity data were soft across metrics in April. We had anticipated a seasonal correction after the strong March rebound but the scale of pullback was sobering, if not worrying. Purchasing Managers’ Index (PMI) data also softened slightly in April in various emerging markets, erasing only part of the improvement witnessed over the past couple of months. That said, a number of East Asian economies had released data which suggest that export and industrial growth was bottoming out. Altogether, we maintain our outlook of a sequential economic improvement sustained by China and a dovish Fed but we cannot stress enough how vulnerable the momentum is to adverse shocks.”

Serge Pizem, Global Head of Multi-Asset Investments at AXA IM exposes his asset allocation views for June: “We are adopting a more cautious stance in our portfolio this month, reducing our equity exposure by downgrading our position on emerging equities to neutral while maintaining our negative stance on eurozone equities. The reason behind this is that we think risks have increased because of the trade war, the lower “Fed put”, and the lack of clear signs that global growth has bottomed out.”

• We are prudent on developed equities given that risks have increased as trade negotiations between China and the US are taking a turn for the worse.
• We remain overweight on emerging debt and US High Yield as a more dovish Fed is supportive for carry positions.
• We maintain Euro core government bonds at neutral as lower growth and falling inflation should cap bond yields.

“Trade war remains front and center. As a result, developed markets (DM) have adjusted slightly lower recently but remain within firing range of their recent highs. Government bond yields have repriced lower with German Bund yields back in negative territory. Therefore, DM equities have a lot less priced in for a downdraft in global trade, that could have negative spillover effects on global growth, than government bonds. Part of this divergence is due to investors’ expectations that the Fed could be forced to exercise their put if an equity market correction were to lead to a tightening of financial conditions. This has helped to cushion any adverse market move and generates a “buy the dip” behavior from investors. On balance, our view is that risks have increased leading us to adopt a more cautious stance in our portfolios.

“First and foremost, trade negotiations between China and the US are taking a turn for the worse with bilateral relations deteriorating quickly. We do not expect China to give in soon and the probability that both sides don’t reach a deal before the G20 summit on June 28 and 29 is clearly rising. Moreover, there are more and more signs that the trade war is gradually morphing into an all-in, full-spectrum economic war, as shown by the recent addition of Huawei, China’s largest technology company, to the “Entity List” in the US which bars it from accessing key US origin technology, putting the company at risk.

“Second, the “Fed put” is likely to be lower than just the moderate selling witnessed so far. The May FOMC meeting was not supportive of the market narrative that the FOMC is moving inevitably toward near-term “insurance” cuts. Moreover, Chair Powell repeatedly characterized recently lower core PCE inflation as "transient".

“Third, we are still waiting for clear signs that global growth has bottomed out. As already mentioned by Laurent Clavel above, April activity data in China came out weaker than expected, with investment, industrial and retail sales all slowing, the latter to the slowest pace since 2004. These mixed numbers arise while the 25% tariffs have not even started to bite. In Europe, despite better growth numbers in the first quarter, the underlying momentum remains weak and the Germany’s manufacturing crisis persists. Lastly, the US economy is likely to slow rather than accelerate to the upside from here.”