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BEST PRIVATE BANK FOR SUPER AFFLUENT CLIENTS IN LUXEMBOURG BIL BOARD Financial financialmarket marketnews news Dear Investors, We have witnessed a continuous meltup of the market. Most observers spend hours discussing whether this is Trumprelated or just an ordinary rebound of the global economy. We will not participate in this speculation, but wish to note that the US market is stretched when it comes to equity valuations. At the same time, leading indicators forecast a reacceleration of growth in many economies over the next 6 months. We also wish to highlight that volatility has been very low. We would be surprised if no tactical, short-term correction was to materialise over the next few weeks as markets are ahead of themselves. From a purely economic point of view, the profitability of corporates is increasing and liquidity is abundant. Inflation is returning and so is pricing power. Let us enjoy this as long as it lasts. Yours sincerely, Yves Kuhn Group Chief Investment Officer Spring 2017 07/12 Valuations signal some vulnerability This US equity bull market is now the second longest ever, up 225% since March 2009, shortly after Obama took office. Age alone does not end the Bull – a recession, catalysed by rising rates or an exogenous shock, has set in shortly after each major peak in the past 25 years. 2017 should bring balance sheet strength, a return to earnings growth after a two-year drought, and rising interest rates. The investment arm of Deutsche Bank has stated that ‘the six-month change in the global composite Purchasing Managers Index (PMI) for new orders reached 2.5 points in January, the strongest positive momentum in nearly five years’. This has allowed US equities to rally by 9%, and US 10-year Treasury yields to move up by more than 0.9% over the same period. All of these moves are broadly in line with the change suggested by key leading indicators, the PMIs, suggesting the recent rally was growth-inspired (rather than Trumpinspired). Europe’s economy is also gathering steam. For now, composite PMI levels for the eurozone are already at 56 (a 70-month high), which could come hand-in-hand with a growth rate of 2% or more. Mario Draghi, the European Central Bank (ECB) President has declared victory over deflation after consumer prices rose to 1.9% (just shy of the ECB’s 2% goal). European sovereign fund outflows have extended to a seventh week as investors begin to shop around for greater returns. As Goldman Sachs stated: ‘High [US] equity valuations alone are not a reason for drawdowns in the short term, if they reflect stable or improving macro conditions; but they indicate elevated drawdown risk.’ The consistent and continuous melt-up by the markets, triggered by a change of flows from fixed income to equities, wrongfooted some investors. The question is who gives in first: those who are sitting on a 9% six-month return or those who give up being by-standers and want to jump into the market at any cost. We will find out over the next few weeks. The market seems to be ripe for tactical correction, and the interplay between the haves and have-nots currently seems to be driving the market higher, inch by inch. Yves Kuhn Olivier Goemans Chief Investment Officer Head of Portfolio Management BIL’s macro outlook for the next six months Over the last six months, manufacturing and employment strengthened in developed economies, while inflation edged up across the board, due in part to flattering base effects and rebounding commodity prices. The monetary policies of the major economies continued to diverge, in line with their central banks’ assessment of country-specific circumstances. As stated by the Bank for International Settlement, while the Federal Open Market Committee (FOMC) raised the target federal funds rate another quarterpoint, and hinted at a somewhat faster pace of rate hikes, the ECB and the Bank of Japan (BoJ) stayed committed to sustaining “lower for longer”. Core fixed income markets and exchange rates reflected this divergence. Where does all this lead us? Interestingly, US GDP growth of 4% would only imply an upside of around 0.5 points for global PMIs over the next six months. Higher commodity prices and easing inflation are supporting a recovery from deep recessions in Brazil, Russia and various other commodity producers. For the entire year, we stick to our forecast of 3.4% 2 for global economic growth, where half of the increase (0.25%) will be carried by re-emerging markets such as Brazil and Russia, and the other half will be carried by stronger growth in the US (2.4% according to the OECD) and Japan. In the euro area, GDP growth will continue at the current modest pace (1.6%), supported by accommodative monetary policy and moderate fiscal easing over the coming years. There is room for more ambitious and effective fiscal initiatives in Europe. There are encouraging signs that business investment may be strengthening, but a high volume of non-performing loans (approx. EUR 1 trillion) and labour market slack (EU unemployment at 9.6%) continue to hold back Europe’s growth prospects. In Europe, headline inflation has been pushed up by higher energy prices, but the recovery is not yet sufficiently advanced to durably raise core inflation (0.9%). We are below the non-accelerating inflation rate of unemployment (NAIRU), which seems to be 5% for the US. For the moment, inflation is tame: US wage increases now stand at approximately 2.8%, or in real terms around 0.5% on an annual basis. In Europe, unemployment rates are rapidly dropping to under 10% (now 9.6%) and Nairu (9%) should be reached within the next 12 months. Inflation is still mild, but the market is beginning to price in rises in inflation. Long-term interest rates have risen globally in recent months, although they remain low by historical standards. In general, rates have climbed 0.5% to 1% this year. A sharp reassessment by markets of the future path of interest rates could result in substantial and widespread re-pricing of assets (e.g. real estate) that have been benefiting from low bond yields. Note that European corporates have 10% lower leverage than their US counterparts. “ Banks are among the main beneficiaries of the reflation theme Equities With US growth momentum nearing its peak and rates increasing further with a hawkish Fed, the potential for an equity correction is growing increasingly stronger. At elevated levels of valuations, this also means more vulnerability to potential shocks. European equities Financial companies – banks in particular – remain the key beneficiaries of rising yields and increasing inflation, as shown in the graph below. On the opposite side, defensive sectors such as real estate, utilities and consumer staples could continue to suffer. 5 Beta of European sectors to the German 10Y yield (1/1/2015 to 15/3/2017) 4 3 2 1 0 -1 -2 An increase in inflation is benefiting corporate earnings, as a stronger top line and better pricing are kicking in. Although higher rates usually argue against multiple expansion, 2017 should see some base effects materialising, driving a strong rebound in commodity-related sectors’ earnings and a continued recovery in financials’ momentum. More broadly, there has historically Real Estate Utilities Consumer Staples IT Healthcare Consumer Disc. Materials Telecoms Services Industrials MSCI Europe Energy Financials -3 Source: Bloomberg, BIL been a strong positive correlation between inflation rates and corporate earnings. The Q4 2016 earnings season showed that European companies posted earnings per share growth of around 8%, and should even experience acceleration throughout the year: sell-side analysts are now expecting growth of 15% for 2017. Short-term sentiment, as measured by the earnings revision ratio (number of upgrades – number of downgrades / number of revisions) is also largely in positive territory in Europe. That said the busy election calendar is likely to bring some periods of uncertainty, as political risks remain high in the region. Evolution of earnings per share growth rates Europe US 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% Q1 15 Q2 15 Q3 15 Q4 15 Q1 16 Q2 16 On the back of this, we remain overweight on value versus growth. We are overweight on the consumer discretionary and industrials sectors. The consumer discretionary sector – and autos in particular – appear attractively valued, whilst being highly leveraged to PMIs. We also favour a selection of industrial companies (namely US-exposed infrastructure stocks), as we believe they might benefit from the potential policy changes and 3 Q3 16 Q4 16 FY 2017 Source: JPM, IBES, BIL stimulus following the election of Donald Trump. In addition, the sector should benefit from an acceleration of global GDP growth, whilst trading at discount valuations to the broader market. Within the growth market, we like the healthcare sector, as the sell-off last year and subsequent de-rating offer good opportunities. In the short term, we are neutral on financials. Banks are among the main beneficiaries of the reflation theme and are still trading at a large discount to the European market and their US counterparts, but the strong outperformance of the sector over the last few months might come to a pause in the short term. US Equities Historically, when the composite ISM (institute for supply management index, an economic lead indicator) has moved above 56, as it did in January 2017, the S&P500 Index was up in 100% of these cases over the next six months. Equities remain under-owned and there are some signs that this is starting to change, with retail inflows finally coming through. The recent increase in yields helps the broadening in sector and style leadership and acts as an indicator of improving pricing power, and should help bring about a shift in asset flows: from deflation hedges (bonds) to inflation hedges (equities). On the other hand, rising yields do have a tendency to undermine valuations in general. This is concerning given that the US is already trading at a stretched price-to-book premium that is two standard deviations higher than its 10-year historical average. However, we believe one needs to see rising bond yields in order to stay constructive in the mid-term. US wage growth is at its highest in this cycle so far, and NFIB (National Federation of Independent Business) intentions to raise price indices have also moved to elevated levels. US earnings momentum has grown stronger. The Q4 2016 reporting season showed outright year-on-year earnings growth in the US after five quarters of earnings recession, with reported 6.3% earnings growth and 4.8% sales growth, outpacing expectations by 2.6% and 0.4%. This positive momentum could be seen beyond the US, as European and Japanese earnings outpaced US ones for the first time in six quarters. The latest global manufacturing PMIs are at their highest levels in 6-7 years, which is consistent with double-digit EPS growth. President Trump and the Republican-controlled Congress have publicly opined the prioritisation of corporate tax reform. In aggregate, the proposed lower tax rate (from 35% to 20%), territorial taxation and the border adjustment are expected to lift S&P500 EPS by 8 dollars (+6%). This impact however could vary significantly by industry. Themes we would like to highlight in the US are the beneficiaries of rising yields and Trump policies. Financials are key beneficiaries of rising bond yields and potential de-regulation. Financials also stand to benefit the most from lower statutory federal tax rates, while being relatively insulated from the adoption of border adjustment tax. Similarly, small & mid-caps stand to benefit relative to large caps owing to their higher domestic exposure. We believe that the rotation out of growth and into value sectors will continue as long as the bond yields move higher and economic activity stays elevated. Japanese Equities In Japan, we are also finally seeing signs of a pick-up in inflation due to the base effect of increased energy prices. With the unemployment rate at 3%, its lowest level since the 1990s, the stage could be set for future wage growth and higher inflation in coming months. The Bank of Japan continues to target a steeper yield curve. The stronger the sell-off on the US Treasury market, the greater the potential for the market to test Kuroda’s resolve to keep 10year Japanese government bond (JGB) yields at 0%, essentially forcing the Bank of Japan to 4 buy potentially unlimited amounts of JGBs. The prospect of such an outcome should put further downward pressure on the yen and brighten the outlook for corporate profits. Historically, one of the many challenges facing Japan has been a relatively unprofitable corporate sector. That is in the process of changing. Improving corporate governance coupled with increased share buybacks has pushed the notoriously low return-on-equity (ROE) up to around 7%. While still low by US standards – partly the reflection of a multidecade deleveraging by Japanese corporations “ European and Japanese earnings outpaced US ones for the first time in six quarters A key question for European rates is when the – this is well above the 20-year average of 4%. While Japanese stocks bottomed in 2012, Japan remains reasonably priced in contrast to the US, just about every other developed market and even many of the emerging markets in Asia. While other markets, notably the United States, have seen prices driven primarily by multiple expansion, Japan has benefited from rising earnings. US, the price-to-earnings (P/E) ratio on the S&P 500 Index has risen by roughly 75% since the market bottomed in 2009. In contrast, since bottoming in 2012, Japanese equity valuations are relatively flat. As a result, Japan remains a value play in an increasingly expensive world. It is revealing to compare the bull market gains in the United States to those in Japan. In the ECB will start to taper Fixed Income Looking at the shorter term interest rates, it is evident that Europe and the US still live in very different economic and political environments. Using two-year interest rates (other short-term rates could be used just as well), we see that the US rate has continued to climb steadily. On the fundamental side, this is a reflection of the already strong economic environment and expectations of further rate hikes from the Federal Reserve. In Europe on the other hand, the rate has been pushed down even further. Even if the economy is improving here as well, we are not yet on strong and sustainable footing; the ECB continues with its forward guidance of low rates. Due to the differing directions of the short-term rates, the yield curves of Europe and the US are taking on different shapes. As discussed earlier, this is important because the yield curve has a large impact on the earnings of various sectors. In Europe, the yield curve has been clearly steepening. Normally, this indicates stronger economic growth, but if we look closer at the time period after the immediate effect of Trump’s victory, we see that the steepening is mainly caused by short-term rates moving even further into negative territory (from -0.6% to -0.8%). History will tell whether the traditional conclusions can be drawn in this type of unprecedented situation. Unfortunately, we feel one cannot be too optimistic at this time, as the main cause is ECB bond buying and political uncertainty. In any case, we do expect the EUR yield curve to continue steepening: slightly higher long-term rates should climb somewhat, while short term rates are low (but not decreasing further). In the US on the other hand, the yield curve has been flattening. Short-term rates have increased more than long-term rates. This is due to expectations that the Federal Reserve will hike short-term rates, while the market is still not convinced inflation will increase dramatically. However, Trump’s planned fiscal spending should lead to a larger increase in 5 long-term rates and a steeper yield curve. At the moment we believe that is more of a story for 2018 than 2017. Despite these differences in the yield curves, we do expect increasing rates in general, which means that one has to pay attention to interest rate risk and focus on investments with short or medium duration. This is especially true for USD investments, where we favour floating rate exposure to benefit from the increasing short-term rates and avoiding interest rate risk completely. A key question for EUR rates is when the ECB will start to taper and end its bond buying program; how it communicates this will be crucial. Current expectations are that the ECB will continue with quantitative easing in some shape or form next year, but at decreased volumes. The market is already starting to speculate about when the ECB will comment on this; most probably it will not happen until after summer. At some point, the market will start to price in a tapering of some sort, which would add further pressure on increasing rates and perhaps more importantly affect credit spreads as the ECB has also been buying corporate bonds. This means that one ought to be very selective when investing in EUR credits, both investment grade and high yield – as the margin of error is very small due to the low yields. We prefer equities (inflation hedge) rather than bonds (deflation hedge) Conclusions Let us summarise our views: -We prefer equities (inflation hedge) rather than bonds (deflation hedge). An interesting momentum is being generated by the renewed pricing power of corporates through steepening yield curves, while equities are highly valued. -European and Japanese equities should benefit more than US equities from a re-acceleration of the US economy. In addition, we continue to think accommodative policy in Europe and Japan will support those markets, while rising yields and policy disappointments will weigh on the US market. -There is favourable economic momentum in Australia and Japan, and we are happy to have an exposure to the MSCI Pacific region. -We are selling our exposure to European high yield securities (yield to maturity 2.7%), as we believe that the yield does not adequately reflect the risk of this asset class. We are taking into account the planned tapering by the ECB later this year. -In addition, we think the sovereigns of core European countries are overpriced. In the short term, the FED might surprise with activity, and: - We might see a flattening of the US yield curve over the next 6 months, as the short end moves up. - In the longer run, however, there might well be a steepening, and this would be beneficiary to financials and value-style investments. - Any relief rally resulting from the French election not bringing about increased risks will provide some mighty tail winds to the euro. Despite experiencing some volatility in the short term, the euro might finish the year at a similar level to where it started in relation to the USD; indeed, the euro might even gain ground versus the USD. A more stable dollar and trend-like global growth create a benign backdrop for emerging markets and commodities alike; this would lead us to close our EM equity underweight and maintain a neutral stance on commodities. 3 to 9 months investment horizon Asset Class • The global growth outlook is slightly accelerating. • We are overweight on European and MSCI Pacific region equities. • Reflation trade will push up yields worldwide. • We remain underweight on government bonds/duration and expect at least two rate hikes in 2017. • 'Make America great again' with a revamp of fiscal policies. • We prefer US Small Companies compared to the large companies that have more international sales. • The ECB will taper sooner or later over the next 8 months. • We are selling European High Yields Bonds (YTM 2.7%) and core government sovereign bonds. • Inflation is back, interest rates are going up. • We are increasing exposure to interest-leveraged sectors such as financials, and limiting exposure to real estate. Yves Kuhn, Group Chief Investment Officer As economic conditions are subject to change, the information and opinions presented in this outlook are current only as of March 16, 2017. This publication is based on data available to the public and upon information that is considered as reliable. Even if particular attention has been paid to its content, no guarantee, warranty or representation is given to the accuracy or completeness thereof. Banque Internationale à Luxembourg cannot be held liable or responsible with respect to the information expressed herein. This document has been prepared only for information purposes and does not constitute an offer or invitation to make investments. It is up to investors themselves to consider whether the information contained herein is appropriate to their needs and objectives or to seek advice before making an investment decision based upon this information. 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