Beware of economic euphoria - blog-axa-im
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INVESTMENT
STRATEGY
By Laurence Boone, Research & Investment Strategy 26 January 2018
Beware of economic euphoria
Eurozone growth keeps surprising to the upside and forecasters are typically too slow to react. We
revise our expectations to 2.5% this year, above consensus.
The European Central Bank has signalled its readiness to tighten policy. We now see more upside to the
EUR/USD and target 1.28 by year-end.
Economic optimism has not made risks disappear though. Comments from politicians, as exemplified at
the recent Davos conference, could prove disruptive for markets and eventually lift volatility.
Normalisation of monetary policy in sight
As the World Economic Forum in Davos comes to a close, it appears that the global economy is riding a
wave of euphoria. Right now economic data hasn’t been this encouraging since before the financial crisis. It
seems it’s time for policy normalisation, or at least, monetary policy normalisation.
It’s time for interest rates to edge up and financial stability concerns to rise, as is usual in this phase of the
cycle, when talks switch from anxiety about the strength of the recovery, to concerns that monetary policy
has perhaps been overly accommodative for too long.
But in our view, economic conditions are as supportive as possible, from the micro perspective (cheaply and
abundantly financed, technology and digital innovation is, lifting productivity at last), to the macro, where the
policy mix remains benign. All of these elements have combined to provide a conducive backdrop for
political errands such as FX talks or trade disruption.
And this is why we believe volatility may soon be back.
Eurozone growth at its highest in ten years
Let’s talk about growth first. As we highlighted in our previous Monthly Investment Strategy, the Eurozone is
now in the spotlight, with markets and analysts continuing to revise their projections upwards. Indeed, soft
data is all heading in one direction. Eurozone Purchasing Managers’ indices (PMI) have climbed to their
highest levels in twelve years, consistent with 4% growth. Additionally, the European Commission’s
Economic Sentiment Index (ESI) is at a ten-year high, consistent with 3% real GDP growth. Looking at
business surveys country by country suggests 3.8% growth in Germany in 2018, 2.8% in France, 2.6% in
Italy and 4% in Spain. Not since 2006-2007, when Eurozone GDP respectively scored 3.2% and 3%, has
economic momentum been so good.
The improvement is broad-based too. Hiring intentions have accelerated, meaning the fall in unemployment
will not only continue but should actually speed-up. PMI export orders are at their highest since 2011, while
the business climate in the construction sector is at a ten-year high. And last but not least, industrial
capacity utilisation has hit its highest level in a decade and continues to grow, suggesting we should
witness a rise in machinery and equipment investments.
Many macroeconomic forecasters are already revising their 2018 figures upwards (with the consensus now
at 2.2%). This echoes 2017, when many repeatedly dismissed business surveys but in the end they had to
revise their Eurozone growth predictions, from 1.4% (median) at the end of 2016, to 2.3%. If we were to see
such an upward shift throughout 2018, starting at 2.2%, that would get us beyond 3% by the end of 2018 –
exactly where business surveys tell us we are heading. More precisely, our analysis suggests that
macroeconomic forecasters collectively exhibit a cyclical bias, under-estimating the depths of recessions
(as in 2009 and 2012) and the strengths of expansions (as in 2015 and 2017).
Against this backdrop, we have lifted our own Eurozone growth projection to 2.5% this year, with upside
risks albeit significantly above consensus (2.2%).The ECB is preparing markets for a gradual exit It seems therefore sensible that the European Central Bank (ECB) and markets accompany these movements with a very progressive financial tightening, in the form of an appreciating exchange rate, as well as the gradual withdrawal of excess monetary policy accommodation. First, the ECB has no interest in leaning against the wind and trying to fight the exchange rate appreciation. Since its forum in Sintra, and rightly so in our view, the ECB has said that a slowly appreciating euro would be endogenous to improved economic conditions. This is what we are witnessing. Second, the ECB, as we previously noted, will slowly prepare markets for less monetary accommodation as the outlook for inflation appreciates – and let’s not forget the Bank’s mandate is to manage headline inflation. This will take several forms in a neatly laid out sequence: As inflation evolves, the forward guidance on the end of quantitative easing will be flagged – by which we mean the pace at which the ECB will go from its current €30bn of asset purchases a month towards zero, after 30 September 2018. We estimate that a trade-weighted exchange rate appreciation of 10% since April 2017 removes 0.4 percentage point from inflation headline after twelve months. Only after asset purchases are reduced significantly to reinvestment will the ECB start normalising rates. The message from the 25 January ECB press conference will potentially have two impacts – a continuing appreciation of the euro, and a re-pricing of hikes further into the future, up to the second quarter of 2019 but possibly accompanied by some steepening as inflation becomes firmer. Risks are not off the table But as the Eurozone joins the US and emerging market growth party, inflation gets closer to target and exchange rates rebalance, is the euphoria justified? In our view, this is a risky assessment. Last year, markets’ anxiety about politics mitigated the positive sentiment related to the firming seeds of growth. This year, market positivity on economics prevents them from pricing in the multiple risks we see looming: Inflation in the US – especially if the dollar continues to weaken and infrastructure spending is added to the tax reforms. Though we believe this could take some time and could lead to a rates tantrum. Volatile exchange rates – as markets know well, whenever central banks appear uncoordinated, exchange rates can become unpredictable. However, in our view, the US government may create boosts of volatility but the US Federal Reserve (Fed) is set to be more reasonable. Trade disruption on the back of President Trump’s decisions on North-Atlantic Free Trade Agreement. This could worry markets on the persistence of brisk growth and especially weaken inflation. In our view, elections are less of a risk, as there is less popular polarisation, though there is potential for trouble across emerging markets should the trade concerns as mentioned above materialise – for example around the time of the Mexican elections. Geopolitical risks (harder to price by nature) in North Korea but also in the Middle East, with a possible impact on oil prices. Perhaps more importantly, we fear the reaction of financial markets should a shock disrupt the ongoing risk appetite, as we have little information on how all the regulatory changes (e.g. Mifid II and others) have affected the capacity of banks and the overall market infrastructure to absorb an abrupt sell-off. Asset allocation: EUR/USD on its way to 1.28 All that being said, we should not play Cassandra. The financial system is much more secure, at least on the banking side, than it was ten years ago. Systemic risk coming from there has diminished but an asset price correction is a possibility. In the meantime, we still have appetite for risk and favour equities over bonds, and European and emerging market stocks over the US, where upside valuations are on the steep side. European equities are benefitting from less rich valuations as well as an attractive tailwind from the macro momentum that could support a further re-rating of financials. Key risks in our overweight view are excessive pressures from an appreciating currency and the structurally low weight of technology in European indices compared to the US and developing markets. In the bond space, we remain underweight duration and prefer high yield over investment grad in credit, and again Europe over the US. In the euro bond space more specifically, we persist in arguing that the ECB’s policy of slow normalisation should not impact the view on peripherals spreads, which remain broadly neutral. But having in mind that better entry points could come ahead of the Italian elections. 2 AXA INVESTMENT MANAGERS – RESEARCH & INVESTMENT INSIGHTS
The main changes to our allocation have taken place in the FX space. First, as a result of the changes to
our macro view on euro-area growth as well as the ECB call for 2018-2019, we revise the EUR/USD year-
end target to 1.28. Second, and perhaps more importantly, we believe exchange rate volatility is back. Not
so much because of monetary policy differentials but due to the possibility of disruptive talks, as exemplified
by Treasury Secretary Steven Mnuchin during the Davos conference. Such talks have the potential to inject
a bout of volatility into markets, against which central banks can do little. Their (when necessary
coordinated) actions can gently navigate the direction and correct undesired trends but they can do little to
prevent disruption from sporadic, barely rational talks.
Download the full slide deck of our January Investment Strategy
AXA INVESTMENT MANAGERS – RESEARCH & INVESTMENT INSIGHTS 3RECOMMENDED ASSET ALLOCATION
Asset Allocation
Key asset classes
Equities
Bonds
Commodities
Cash
Equities
Developed
Euro area
UK
Switzerland
US
Japan ▲
World
Emerging & diversification
Emerging Markets
Euro-area banks
Fixed Income
Govies
Euro core
Euro periph
UK
US
Inflation
US
Euro
Credit
Euro IG
US IG
Euro HY
US HY
EM Debt
Short duration
Legends Negative Neutral Positive Last change ▲ Upgrade ▼ Downgrade
Source: AXA IM Research – As of 26 January 2018
4 AXA INVESTMENT MANAGERS – RESEARCH & INVESTMENT INSIGHTSFORECAST SUMMARY
2017* 2018* 2019*
Real GDP growth (%) 2016
AXA IM Consensus AXA IM Consensus AXA IM Consensus
World 3.2 3.7 3.9 3.8
Advanced economies 1.7 2.3 2.4 2.1
US 1.6 2.3 2.3 2.5 2.5 2.1 2.0
Euro area 1.7 2.3 2.3 2.7 2.1 2.1 1.6
Germany 1.9 2.5 2.3 3.1 2.2 2.5 1.6
France 1.2 1.8 1.8 2.3 1.8 2.0 1.6
Italy 1.0 1.6 1.5 1.6 1.3 1.0 1.2
Spain 3.2 3.1 3.1 3.0 2.5 2.0 2.2
Japan 0.7 1.7 1.5 1.2 1.3 1.0 0.7
UK 2.0 1.5 1.6 1.7 1.5 1.8 1.6
Switzerland 1.3 1.0 0.9 1.8 1.9 1.5 1.6
Emerging economies 4.4 4.8 4.9 4.9
Asia 6.4 6.6 6.4 6.4
China 6.7 6.8 6.8 6.5 6.4 6.3 6.2
Rest of EM Asia 6.1 6.2 6.4 6.5
LatAm -0.7 1.3 2.0 2.4
Brazil -3.5 1.0 1.0 2.4 2.6 2.3 2.5
Mexico 2.9 2.0 2.1 2.1 2.2 2.1 2.4
EM Europe 1.6 3.7 2.7 2.7
Russia -0.2 1.9 1.8 1.9 1.9 1.8 1.8
Poland 2.9 4.3 4.3 3.8 3.7 3.7 3.5
Turkey 3.2 5.5 6.2 3.6 3.7 3.6 3.9
Other EMs 4.3 2.8 3.7 3.6
Source : Consensus Economics, FMI et Recherche AXA IM − As of 26 January 2018
2018* 2019*
CPI Inflation (%) 2017
AXA IM Consensus AXA IM Consensus
Advanced economies 1.6 1.9 2.0
US 2.1 2.2 2.1 2.4 2.2
Euro area 1.4 1.4 1.4 1.9 1.6
Japan 0.3 0.6 0.8 0.9 1.1
UK 2.7 2.6 2.6 2.0 2.1
Switzerland 0.2 0.6 0.7 0.6 1.0
Other DMs 1.6 2.6 2.2
Source: Consensus Economics, IMF and AXA IM Research − As of 26 January 2018
These projections are not necessarily a reliable indicator of future results
AXA INVESTMENT MANAGERS – RESEARCH & INVESTMENT INSIGHTS 5FORECAST SUMMARY
Current Jan.-18 Feb.-18 Mar.-18 Apr.-18
Date 31st -- 21st --
United States - Fed 1.25 - 1.50
Rates (bp) / QE -- -- +25bps --
Date 25th -- 8th 26th
Euro area - ECB 30bn until Sep-18
Rates (bp) / QE QE 30bn -- unch unch
Date 23th -- 9th 27th
Japan - BoJ -0.1 / 80tn (JGBs)
Rates (bp) / QE -- -- unch unch
Date -- 8th 22nd --
UK - BoE 0.25
Rates (bp) / QE -- unch -- --
Source: Datastream and AXA IM Research – As of 26 January 2018
Target
Asset classes Reference Current
3 months 12 months
Rates (%)
US 10Y Treasury 2.62 2.65 2.70
German 10Y Bund 0.61 0.55 0.80
British 10Y Gilt 1.41 1.30 1.70
Japanese 10Y JGB 0.09 0.10 0.20
Credit (bps)
USD Investment Grade BofA C0A0 93 100 115
EUR Investment Grade BofA ER00 77 85 100
USD High Yield BofA H0A0 328 340 380
EUR High Yield BofA HE00 253 260 300
Equities
US MSCI US 2,703 2,750 2,800
Eurozone MSCI Euro 234 240 250
Japan MSCI Japan 1,120 1,150 1,200
Emerging markets MSCI EM 1,263 1,300 1,400
FX
EUR/USD 1.24 1.25 1.28
USD/JPY 109 110 110
GBP/USD 1.41 1.38 1.36
Source: Datastream and AXA IM Research – As of 26 January 2018
These projections are not necessarily a reliable indicator of future results
6 AXA INVESTMENT MANAGERS – RESEARCH & INVESTMENT INSIGHTSOur Research is available on line: http://www.axa-im.com/en/research
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