Roads to nowhere

With trade tensions between China and the US subsiding once again and hopes reviving for fiscal stimulus policies, the first part of the month saw considerable sector rotation between defensive and cyclical stocks. The degree of that rotation was heightened by the extreme positioning of many investors who had long since turned their backs on the most cyclical segments of the market.

As dividend yields in many cases exceed the yields on core sovereign bonds, there is still fairly little risk of a sharp stock-market correction, and a constructive approach to equity exposure remains appropriate. However, our core portfolio still gives priority to maximum quality names. We feel they are poised for further outperformance in the current period of both structurally and cyclically low growth, while monetary policy is approaching the outer limit of what it can accomplish. But as those stocks have already gained a lot of ground, we continue to pay close attention to valuations. For example, though we have sold a large share of our holdings in the promising fintech sector, whose stock prices have done extremely well, we have also bought a stake in Square. This Silicon Valley-based company is a key provider of payment solutions for merchants like bakers, florists and coffee-shop owners. We have maintained our small, tactical exposure to European banks as a means to keep our portfolio balanced, since the European Central Bank expressed the desire in September to offset the damage being done to banks by its negative interest-rate policy.

ECB President Mario Draghi has announced a set of monetary easing measures, including rate cuts, the resumption of its asset purchase programme, less stringent parameters for Targeted Longer-Term Refinancing Operations (TLTROs) and tiered deposit rates for credit institutions. In the United States, Jerome Powell has lowered the Fed’s benchmark rate by 0.25%, but still contests the idea that this marks the beginning of a genuine cycle of monetary policy easing. As those moves were to a large extent expected, yields on core sovereign bonds eased in September after hitting record highs in August. That consolidation was also fuelled by the hope that trade tensions between China and the US, which had sent shock waves in August, would soon subside. In response, we scaled back our modified duration, particularly in Europe, where yields had jumped to dizzying levels.

We are nonetheless sticking with our positioning geared to a flattening yield curve and converging spreads on non-core eurozone bonds, above all Italian and Greek. In the United States, the Fed is still under pressure to take a more dovish stance, not only to sustain a domestic economy that shows increasing signs of weakness, but also to deal with strains in the money market and a global economy still lacking in pep. We are therefore maintaining our constructive view of US Treasuries. In light of the stretched valuations of corporate bonds, we are continuing with our highly selective approach. We still hold subordinated bank bonds, an asset class that we expect to benefit from the introduction of tiered deposit rates by the ECB. In the emerging world, we have maintained limited holdings of Turkish debt denominated in strong currencies now that falling inflation is giving the country’s Central Bank greater leeway.

The changing interest-rate differential between the United States and Europe should have given the single currency a boost – yet the greenback has continued to appreciate against the euro. The Federal Reserve’s members are apparently confident that their dovish turn will be short-lived, and that belief, along with a number of surprises in the US economy that have won approval from global investors, has kept the dollar strong. The greenback is caught between two contrary currents. On one side, it is being buoyed by the repatriation of funds from abroad by American investors and by a cash shortage in US money markets. On the other, the currency is overvalued and the country’s twin deficits – trade and fiscal – are both still getting worse.

As we apparently have a less bullish verdict on the state of the US economy than the Fed and the financial markets do, we are maintaining our cautious stance on the dollar and hedging part of our dollar exposure arising from investments in US assets. We also believe that with elections coming up in the country, the debate over fiscal stimulus financed by additional debt – an approach favoured by several Democratic hopefuls – could rekindle investors’ fears.