Market sentiment indicators have become more neutral while risk premiums remain attractive. Weighing the risks and opportunities, we maintain our balanced asset allocation stance, with small overweights in equities, real estate and spreads. We are underweight government bonds, as the underlying risk balance has become less favourable with the US Federal Reserve likely to hike interest rates for the first time in nine years.
Risk premiums in bonds and equities near historic averages
Risk award is attractive
Most asset classes have recovered from the late summer market correction. A stabilization in the oil price and emerging market data, combined with a dovish European Central Bank (ECB) and a stronger US dollar was enough to turn markets around. Investor sentiment has become more neutral, although the consensus underweight in commodity-related assets, including emerging markets, remains well in place. Given the more neutral stance in behavioural factors, risk premiums may give better medium-term guidance. Premiums are in line with their historic averages for government bonds and higher than average for equities (see chart).
Economic consequences of terror attacks should be limited
Risks can change and we may need to assume a higher risk premium to account for a terrorist fear. It is too early to draw firm conclusions about the effects of the recent attacks in Paris, and while our base case for now is that the economic impact will be limited, we recognize the risk that the consequences could be longer-lasting, especially if the attacks turn out to be the start of a sustained terrorist campaign. If this were to happen the debate about the refugee crisis would probably intensify, which may increase the risk of partially closed internal EU borders.
Such a scenario would also further test the political cohesion within the euro area. A certain degree of “political glue” will be needed in the coming years to complete the construction of the institutional edifice that supports the monetary union. Over the past few years important steps have been taken towards fiscal and banking union. In its role as single regulator, the ECB has also put mechanisms in place that entail an increased incidence of common rules, as well as more risk-sharing in the form of unlimited liquidity provision to the banking system, outright monetary transactions and quantitative easing (QE). Many of these policies are temporary and will in due course have to be replaced by more lasting solutions hammered out by the region’s politicians.
Government bond yield gap widening
Government bond markets have meanwhile started to focus on a Fed rate hike before the end of the year. With expected monetary policies of the Fed and the ECB going into opposite directions, the difference between US and German 10-year yields has started to widen again. The gap is not yet back at the maximum that was reached earlier in the year, but the driver for the widening is a bit different now. In early spring the gap grew as a result of falling Bund yields following the announcement of the ECB’s QE program. Now, with Fed tightening measures likely before the end of the year, the gap is widening because of higher US Treasury yields, and may very well move further towards the previous peak.
Corporates also on divergent paths
Divergence is also a major theme for equities. The US is further ahead in the business cycle than the Eurozone or Japan. Global earnings growth bottomed in 2015 but this figure hides very different trends. In the US earnings growth declined and turned even slightly negative; in the Eurozone and Japan, earnings grew at double-digit pace. A similar trend is also evident in financial leverage and corporate spending. One of the drivers of this divergence is the strength of the US dollar, which favours non-US companies over US companies because of translation effects and the loss of competitiveness for US exports. It is no surprise that during periods of dollar strength, relative earnings momentum for non-US corporates improves and the equity markets of the Eurozone and Japan perform better.
Margins likely to converge
A second driver for the growth divergence is linked to the level of corporate margins. If we strip out the financial sector and the energy sector, US operating margins are close to record highs while Eurozone margins have hardly recovered from cycle lows. The gap between the two regions is at its highest level in more than a decade. Going forward we believe that this margin gap will gradually close from both sides: higher in the Eurozone, lower in the US.
Part of the explanation is linked to corporate spending patterns over the past years. US companies have spent relatively more on capex as a percentage of sales than Eurozone or Japanese companies. At the same time, US companies have increased their financial leverage as they optimized their cost of capital and maximized shareholder value through debt-financed share buybacks. These two elements will impact net profit margins through higher depreciation charges and higher interest charges.
The biggest impact may come from rising wage costs. With the US labour market becoming tighter, the first signs of a wage pick-up may become visible. In November, US hourly earnings rose by 2.5%, the highest rate since 2009, although this is linked to labour productivity growth and is not enough to presage wage cost pressures. In the Eurozone, wage costs are less of a topic given the still-high level of unemployment, although it has been improving.
Japan corporates have room to strengthen balance sheets
Japan is another case. Operating margins have already returned to record-high levels but are still below the levels observed elsewhere. The return on equity is still below international standards. We think that corporate profitability in Japan will be driven by cyclical, behavioural and structural factors. The cyclical part will be driven by a weak yen, especially as the Fed starts hiking interest rates, and by stabilization in emerging market growth. Behavioural factors are linked to changes in corporate governance, shareholder activism and a bigger focus on return on equity. The financial surplus of Japanese companies has been rising and companies have reduced leverage to record-low levels. This means companies have room to optimize balance sheets and reduce the cost of capital. On the structural front, we note the efforts to lift nominal growth in Japan to a structurally higher level. More fiscal and monetary stimulus can be expected.
Close overweight in Asia ex-Japan
Within our equity allocation, we closed the overweight in Asia ex-Japan. The absence of a rebound in the industrial metal space limits the short-term potential of the region. We maintain our overweight stance for Japan and the Eurozone.