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Asset Allocation update May

21 May 2019

Last month brought also some setbacks though. Leading indicators this month failed to further fuel the optimism about a turn in economic momentum.  Next to that the trade dispute between the US and China escalated. The latter was reason to reduce our outlook for emerging market equities. Both were the reason we have reduced our outlook for the equity market to negative.

Somebody forgot to water the green shoots

After seeing some green shoots in important indicators of future economic development last month, this month the numbers came in well below expectations. The improvement in PMI’s across Asia and -most important- the jump in Chinese business confidence reversed this month. While not falling back to the lows of earlier this year, the pick-up in the leading indicators failed to continue. A notable setback for the global economic outlook, as much of the optimism about renewed momentum in the economy is based on the expectation that policy stimulus in China will spur global growth. The ISM manufacturing index in the US fell to 52 (from 55) which indicates a notable slowdown in production. Real industrial production and retail sales data came in lower than expected as well this month. Growth in manufacturing stalled in the US while in China it fell to the lowest level since 2009. In the Eurozone economic development seems particularly soft. The nowcast of the economy is pointing at no growth while leading indicators continue to drift lower. Uncertainty about political developments, both internal with Brexit and stability of the Eurozone as well as external effects of a possible escalation of protectionism clearly have an impact. The other side of the story is that policy makers have picked up on the soft patch in economic data some time ago. All major central banks have turned more dovish  as economic growth slowed and inflation pressure resided. Thus, financial conditions have eased significantly. In combination with the Chinese stimulus mentioned before the consensus is that H2 of this year we will see a notable pickup in growth. Those expectations were confirmed by the green shoots we saw last month. However, given the recent reversal and the overall trend in the economic data still pointing to a growth slowdown we are more cautious with our outlook.

“Markets have been on an exceptionally strong rally this year.”

Why (not) equities?

Markets have been on an exceptionally strong rally this year. Certainly it was partially justified as the excessive negativism we saw at the end of last year was being priced out. As mentioned in the beginning we have decided to turn negative on equities as consensus has become too optimistic on the outlook and we thus see risk to the downside. There are some arguments to remain constructive on the equity market though. First, equity markets are not overly expensive. Price to earnings ratios are not excessive relative to historic levels. Due to policy easing interest rates have declined to multi-year lows and  dividend yields in developed markets are much more generous than bond yields. Next to that credit spreads are still very tight. A signal that markets are not expecting a rise in corporate defaults. Finally, the most recent reporting season was notably better than expected. However, corporate earnings are a point of concern as growth has all but stalled. Growth is only expected to come back at the end of 2019 when the economic outlook improves. Given our doubts about a quick turn in economic momentum we believe markets have become too optimistic. Easier monetary policy has been an important factor in pushing markets higher this year as low yields drive investors to riskier markets. At this point we see the outlook in the fixed income market as a risk, given that bond markets are now pricing in a rate cut in the US by the end of this year. While lower rates are good, it is unlikely the Fed will decide to cut the interest rate unless economic conditions worsen significantly from this point. One cause for that could be a new escalation of the trade war, which has flared up over recent weeks and is the main reason for us to change our outlook for Emerging Market equities back to neutral. The failure of leading indicators to continue inflecting higher is the reason we have cut our outlook for the equity market as a whole to negative.

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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