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U.S Relationary Positioning is Likely To Be Tested



 U.S. Reflationary Positioning is Likely To Be Tested

Investor U.S. corporate profit expectations for 2017-8 are resting primarily on meaningful corporate tax cuts, a pro-business U.S. backdrop, domestic deregulation, capital repatriation and infrastructure spending. Post the Nov 8th U.S. election, asset prices such as U.S. equities have performed as follows: S&P 500 +7.6%, DOW JONES +10.2% and NASDAQ +9.5%. Declines in equity correlation and volatility have been more conducive to stock selection i.e. due to less frequent ‘risk on’ and ‘risk off’ market moves. From our perspective, we continue to favor specific U.S. large cap equities (e.g. tech, healthcare and energy) with valuation discounts, clear competitive advantages and ample capital return capacity. On the U.S. Treasury front, we note that the 10 Year Treasury yield currently stands at 2.39% - despite firming U.S. and global inflation; and well anchored interest rate hike expectations by the Fed. We also note that Chinese policymakers have recently been tightening monetary policy on the margin. Investor reflationary positioning is likely to be tested as policy uncertainty (e.g. U.S. border tax adjustment) and political risk (e.g. European elections) create volatility episodes.

U.S. wage inflation is one of the key market focal points, as prospective fiscal spending will likely be implemented at a time whereby the U.S. labor market is near full employment. Along with a recovery in energy prices (e.g. oil), wage inflation expectations have lifted broader inflation expectations (~2%). Elevated U.S. job openings point to a skills gap that may cause wage pressures. From our portfolio perspective, we prefer corporations with pricing power and below average wage sensitivity e.g. tech and healthcare leaders. Large cap equities with high free cash flow generation are also likely to withstand a more meaningful pick up in real interest rates. Perhaps the biggest unknown for 2017-8, is how U.S. trade policy will evolve. As we can see below, wide U.S. trade deficits will likely cause further trade frictions.




In our view, reflationary U.S. market positioning seems one-sided at this juncture (i.e. extended net selling position of U.S. Treasuries and U.S. equity volatility; and elevated net buying position of U.S. dollar index futures). The set-up of elevated U.S. equity valuations and subdued volatility measures, creates reasonable scope for some mean reversion in equity volatility. We look to be opportunistic on any policy missteps, trade frictions or any rise in political risk; particularly as we approach a busy election calendar in Europe (Dutch elections Mar 15, French elections April 23rd /May 7th, German elections in Sept. and potentially Italian elections in June). Ironically, apart from creating more attractive investment opportunities, a pickup in market volatility may curb the pace of interest rate expectations and reduce the USD earnings headwind for U.S. corporations with high international exposure. USD sensitive sectors such as energy and technology would likely benefit in such a scenario.       




Lastly, we note below that election uncertainty has been creeping in the sovereign European debt market. Yield spreads in countries such as France and Italy have been widening in the past month vs. German Bunds. Key European issues such as immigration and terrorism, have lent support to anti-EU candidates such as Geert Wilders in the Netherlands and Marine Le Pen in France. These candidates are currently leading in their respective country polls. Dutch debt yield spreads have not widened materially as the market is questioning the ability of Wilders to form a functioning government and in France, polls indicate that even if Le Pen won the first election round, she appears to be losing the second election round. Yet, such populist movements are adding to political and policy uncertainty; especially as Germany appears to have dis-proportionately benefited from ECB monetary policies and a subdued Euro currency. We illustrate below that Germany sports a record current account balance of 8.8% which dwarfs other European and global exporting peers (as a % of GDP). Therefore, anti-EU sentiment and rising state nationalism will likely create volatility episodes.



In conclusion, reflationary positioning is likely to be tested as policy uncertainty and political risks arise. In U.S. equities, we continue to be selective, with a preference for dividend growers and industry leaders. We favor exposure to tech and healthcare global leaders with secular growth prospects and U.S. centric companies that would be prime beneficiaries of U.S. tax reform e.g. telecoms.


Christos Charalambous CFA

Senior Strategist


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