Our 2Q Market Outlook “Reality “Trumps” the Reflation Trade,” evaluates the recent retreat in risk assets, trends in global equities, the impact of a strong U.S. dollar, and continued political uncertainty under the Trump Administration. Key points include:
- Policy expectations and synchronized global growth will continue to be the biggest market considerations for investors this year.
- The U.S. dollar will be critical in determining this year’s winners and losers.
Risk assets continued their relentless post-election march during the first two months of 2017. Buoyed by the selloff in the US dollar, emerging markets bested global markets in both US dollar and local currency terms. The Eurozone was a close second outperforming both the U.S. and the MSCI All-Country World Index (ACWI) in local currency terms. Japanese equities, however, halted their Q4 2016 gallop with a negative absolute return. On the sector front, tech came out on top consistently across regions while reports of elevated inventories as well as an unwinding of extreme net long positioning among both commercial and non-commercial traders led to negative energy sector performance. Health care, consumer discretionary and consumer staples outperformed the broad market, while financials, materials and telecom services trailed the MSCI ACWI.
Our Q1 Outlook entitled “Who Knows? Known Unknowns and Unknown Unknowns” pinpointed risks to the seemingly unbridled bullish consensus undergirded by hopes that the Trump Administration would roll back Obamacare, financial and energy regulation and re-open fiscal spigots through a combination of tax reform and infrastructure spending. Indeed, since early March, some of the risks discussed in the paper began to challenge this consensus. Accordingly, the S&P 500 has fallen by 1.8% after hitting a record high on March 1st. Treasury yields have also backed off their highs and credit spreads have widened modestly. As shown in Table 1, many of the assumed post-election winners, such as higher tax bracket small cap stocks and financials (that would be expected to benefit from a roll-back of Dodd Frank) underperformed after the new President was inaugurated. Healthcare facilities rebounded, suggesting that many investors see failure of Obamacare replacement legislation as threatening the broader Republican agenda.
While this recent retreat in risk assets has led some investors to question the sustainability of the reflation trade, we simply view it as a pause which right-sets the overly ambitious expectations around both the scope, pace and effectiveness of the new administration’s market friendly policies. The real story is that global equities are being supported by strengthening economic data. (See Chart 1). This improving macro-economic backdrop is leading to more positive earnings revisions across the board. Indeed, only in the Emerging Markets do negative earnings revisions exceed positive revisions and even there, the ratio has been improving. (See Chart 2). For Q2, we continue to overweight European and Japanese equities at the expense of U.S. equities; while we are neutral to EM equities. Within the U.S. portfolio we are overweight value and smaller names in light of better entry points presented by their Q1 slide. Our sector positioning remains pro-cyclical, with the largest overweight in the Financial sector. However, our tactical models also call for an overweight to the more defensive Healthcare and Telecomm sectors. (Please refer to Table 2 and Table 3below. for our sector and regional positioning). A scorecard on our Q1 positions is provided on Table 4 below. While we believe that, particularly against the Japanese Yen and commodity exposed EM currencies, the dollar bull run has more legs to go, we are reducing our hedge against the Euro which as discussed in the special section analyzing the likely path of the U.S. dollar, is the most likely candidate to stabilize against the greenback. In recognition of China’s growing importance within the Capital markets, we briefly discuss the impact of the inclusion of some China A shares in the MSCI Emerging Markets Index.