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Asset Allocation Update August 2017

Flaring geopolitical tensions

Last week, high numbers of equities were sold as a result of growing tensions between the United States (US) and North Korea. At the same time, credit spreads widened and ‘safe’ currencies, such as the Japanese yen and the US dollar, increased in value. We believe that the flight to safe havens will be of short duration. In our opinion, the situation will not develop beyond verbal intimidation; a military conflict would seem unlikely as there is too much at stake for both parties. On the one hand, the US is nervous of the adverse impact on South Korea and Guam in the event of military intervention in North Korea. On the other, North Korea is scared of its regime being brought down if it does launch a nuclear attack. After all, such behaviour would not be tolerated by the rest of the world. Experience tells us that geopolitical tensions only have a lasting effect on risky asset classes if they fundamentally alter the economic situation. This is not the case here. Financial markets have already started to rally again. The purely sentiment-driven fluctuations were of short duration.

Earnings display robust growth

Earnings figures over the second quarter of 2017 and earnings forecasts for the individual regions were positive. Earnings and revenue per share were up in all regions. The largest increase of over 20% was in Japan, where companies profited from the cheap yen in particular. The outlook also remains positive. Not only does the Japanese central bank, in contrast to many other central banks, continue to pursue an expansionary policy, the economy is also expected to continue to grow above trend. Earnings in Europe were up by 12% compared to a year ago. In spite of the strong growth, there was a muted response from investors. The fact that the euro rose sharply in value over the past quarter may play a part here. This could form a headwind for earnings growth. Future earnings expectations have therefore been adjusted downwards slightly. The strong euro is also the reason that European investors have noticed little of the record levels being achieved time and again on the US equity markets. While the S&P500 index has already increased by over 10% in US dollars this year, there is barely a positive return when converted into euros. At 10%, US earnings growth over the second quarter was a fraction lower than in Europe. Earnings forecasts are stable. Emerging markets’ earnings figures were again positive. The cyclical outlook is therefore good. All in all, we continue to be positive about equities, especially in Asia ex Japan and emerging markets.

“In spite of the favourable economic climate and declining overcapacity, inflation remains low. ”

Inflation set to rise

In spite of the favourable economic climate and declining overcapacity, inflation remains low. The GDP gap has almost been closed in the US. Unemployment stands at about the Non-Accelerating Inflation Rate of Unemployment (NAIRU). This would normally create wage pressure. Yet average wage increases remain low, at least at first sight. According to the US system of central banks (the Fed), looking at average wage increases does not take enough account of changes to the composition of those members of the working population in jobs. Firstly, average wage pressure is being restricted by the fact that many low-skilled workers have returned to the US job market over the past few years. Secondly, wage inflation is being restricted by the ageing population. Older employees are being replaced by younger ones, who usually earn less. This has a downward effect on the total wage bill, causing growth to be lower than it actually is. We expect (wage) inflation to rise over the next few quarters and that the Fed will continue to normalise its monetary policy.
Tightening mode
We anticipate a further interest rate increase by the Fed this year. In 2018, we expect as many as two or three interest rate hikes, significantly more than the markets are currently pricing in. When the central bankers meet for their annual get-together in Jackson Hole at the end of this month we could well learn more about their plans for monetary tightening. Given the strength of the euro, we believe that the President of the European Central Bank, Mario Draghi, will do his best not to come over as too keen on tightening. Nevertheless, we still anticipate higher government bond yields as a result of the gradual switch to a less expansionary monetary policy.  

Kempen Capital Management N.V. (KCM) is licensed as a manager of various investment funds and to provide investment services and is subject to supervision by the Netherlands Authority for the Financial Markets. This information may not be construed as an offer and provides insufficient basis for an investment decision.

The Asset Allocation Desk

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