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May 2017 Capital Markets Monthly As the economy awakens to spring, political risks and side effects loom Just as the merry month of May is about to start, sentiments on the markets are mixed. On political soil, growth of a carefree spring mood is hesitant at best. Although the first major stumbling blocks inherent in Europe’s 2017 election super-cycle seem to have been overcome, the surprising move to bring parliamentary elections forward to 8 June in the UK has renewed political uncertainty after England filed for divorce from the European Union at the end of March, as expected. It remains to be seen whether the possible strengthening of prime minister Theresa May’s mandate proves to be a game changer for what look like being difficult Brexit negotiations. In the US, president Donald Trump is having to deal with resistance on the domestic policy front, which is delaying the implementation of his agenda. By contrast, the global economy at least seems to be following nature’s example as spring gets underway. The fledgling economy is sprouting and thriving in nearly all key regions. The “soft” mood indicators are, however, racing ahead of the “hard” economic data, a phenomenon that is particularly true in the US. So, while the strength of the growth signal for the US economy is shrouded in doubt, our expectation that the global economy will slightly exceed its growth potential remains supported for the time being. At the same time, the increasing pace of economic growth is not expected to be consistent over the coming months. At least the scenario does not lend itself to renewed expansionary efforts on the part of the major central banks. The US Federal Reserve, for example, recently indicated that it was not only planning further rate hikes but also might start returning the size and composition of its balance sheet – which is currently worth trillions – back to normal as the year progresses. It intends to throttle or desist from reinvesting, both in US Treasuries that are approaching maturity and in mortgage-backed securities (MBS). Accordingly, the signs are growing that global central bank liquidity could peak in the first half of 2018. The global economy follows nature’s example as spring gets underway. Ann-Katrin Petersen Vice President Global Capital Markets & Thematic Research As of 27/04/17 Equity Indices Status FTSE 100 7,211 DAX12,444 Euro Stoxx 50 3,567 S&P 500 2,389 Nasdaq6,049 Nikkei 225 19,197 Hang Seng 24,615 KOSPI2,205 Bovespa64,677 FXStatus USD/EUR1.088 Interest Rates % USA 3 Months 2 Years 10 Years Euroland 3 Months 2 Years 10 Years Japan 3 Months 2 Years 10 Years Raw Materials Oil (Brent, USD/Barrel) 1.17 1.26 2.31 -0.33 -0.73 0.35 0.06 -0.20 0.02 50.7 CapitalMarketIndicator Bond Funds Equity Funds New Publication “Active Management in Times of Disruption” www.allianzglobalinvestors.de What does this augur for the financial markets? • T he prevailing “reflation theme” is currently still supporting the equity markets. However, the boost from oil prices – which are higher year on year – and surprisingly positive economic data are set to gradually lose pace. • A s inflation rises and the prospect of the central banks gradually returning their monetary policies to normal (European Central Bank) or continuing to do so (Federal Reserve), the upward pressure on yields persists on the bond markets, especially in the US. In these conditions, keeping an eye on bond duration risks is advisable. • P olitics remains a key issue for investments. In Europe, the super election year could produce some surprises and occasional hefty fluctuations on the financial markets – although favourable election outcomes might also present opportunities. Doubts about the effectiveness of – basically dollar-positive – “Trumponomics” are increasing in the US. What is more fun in spring than defying unwanted proliferation with a colourful bed of mixed flowers? I believe the same holds true for investments. Ann-Katrin Petersen Allianz Global Investors: Capital Income: Dividends – May 2017 Markets in Detail Tactical Allocation, Equities & Bonds • Equity markets are still being supported by the “reflation theme” – expectations of continued economic revival around the world coupled with rising inflation rates. • The boost to inflation from oil prices – which are higher year on year – will, however, gradually dissipate. Equally, the pace of economic growth cannot be expected to increase consistently over the coming months. • Given the present valuations of a range of asset classes and in the light of increased political uncertainty, enhanced volatility remains likely. • On the bond markets, the upward pressure on yields will continue, especially in the US. Keeping an eye on bond duration risks is therefore advisable. German equities US equities • Surveys among companies, such as the ifo and purchasing managers’ indices, indicate that the German economy will get off to an energetic start in the second quarter of 2017. • Export-oriented companies should enjoy a further boost from the global economy. In contrast, consumer confidence is expected to suffer somewhat due to higher inflation and the recovery in the oil price. Nevertheless, given the robust state of the labour market, there are no grounds for scepticism here. Within the Eurozone, Germany continues to have the lowest unemployment rate. • In terms of their long-term average, German equities appear to be slightly overvalued according to the Shiller price/earnings (P/E) ratio. • Historically low interest rates combined with expansionary Fed policy has helped lift US equity valuations to high levels. This creates a drag on return potential in the long run. • Solid macro data – particularly in the labour market – supports the all-time highs in US equities – at least for now. The US business cycle is however maturing, which suggests approaching headwinds: e.g. lower profit margins due to higher wages. • US large caps are more exposed than domestically oriented small caps to shifts in the value of the US Dollar. European equities • To date, Eurozone economies have remained stable despite the political challenges. Sentiment indicators are pointing towards continued solid economic growth overall with pace and breadth increasing in the second quarter 2017, although there is little prospect of any further positive surprises. • Domestic demand will probably remain the key driver of economic growth in the currency union. Although the gradually rising inflation rate will reduce purchasing power, the steady increase in employment will support consumer spending. Added to this, the economy will continue to enjoy support from extraordinarily low interest rates and the low value of the Euro versus other currencies. • Although the UK economy proved to be surprisingly robust following the shock of the Brexit vote, with gross domestic product growth actually increasing in the second half of 2016, it should lose momentum noticeably as the year progresses. Uncertainty surrounding the economic repercussions of leaving the EU will probably dampen the propensity to invest. • Based on the cyclically adjusted Shiller price/earnings ratios, valuations in the European equity segment are slightly above their long-term average, with some individual European countries still appearing more attractive than other markets. Japanese equities • Helped by the weaker Yen exchange rate and brighter prospects for the global economy, export momentum may well be one of the key reasons for the Japanese economy growing somewhat faster this year than has recently been the case. • In February, the Japanese unemployment rate fell unexpectedly to 2.8%, its lowest level in 22 years. Price trends also provided positive surprises recently. Overall, however, “Abenomics” has still not managed to get inflation on a sustained upward path. As a result, the Bank of Japan will probably continue its policy of “quantitative and qualitative monetary easing with yield curve control” for the time being. • Japanese share prices remain closely tied to the development of the Yen. Emerging market equities • In the emerging markets, the signs are pointing to a moderate acceleration in growth, due mainly to the continued loose economic and fiscal policy in China and growing stability in the two heavyweight economies Brazil and Russia, helped not least by the recent hike in commodity prices. • Nevertheless, there are still risks. Indeed, in a number of emerging markets, expansionary economic policy is accompanied by growing imbalances, in particular a high and increasing level of private debt and inflationary property prices. In addition, the stronger US Dollar will have a temporary negative impact, inasmuch as the cost of servicing debt will increase in local currency for the large number of Dollar-denominated loans. 2 Allianz Global Investors: Capital Income: Dividends – May 2017 • In terms of the Shiller price/earnings ratio, valuations of emerging market equities continue to be relatively attractive. • Tactical overweighting might be advisable although investors with a longer-term horizon should tend towards neutral. Sectors • Given that reflation expectations have already moved upwards, bond yields remain the key for the recovery in more cyclically oriented value stocks to continue. We like US banks as a play on steeper yield curves, at the expense of sectors like consumer staples or utilities. • Structurally, we still recommend the dividend style, because in an environment in which overall long-term growth prospects are sluggish, dividends remain an important factor for equity returns. Investment theme: Capital income restrictive monetary policy, should further encourage the cyclical increase of US Treasury yields. In fundamental terms, US Treasuries are still overvalued, despite the recent correction, although the extent of overvaluation has decreased. • In the UK, continuing the loose monetary policy following the Brexit vote should help to support the Gilt markets. At the same time, though, higher import price inflation due to the exchange rate should not be ignored. • There are no signs of pressure on Japan’s government bond yields, particularly as the Japanese central bank is anchoring yields on 10-year bonds at 0%. • Lack of compensation for duration risk highlights the vulnerability of government bonds. Negative long-end term premia have regularly been a harbinger of rising interest rates. Our advice for the bond segment would therefore be to shorten duration. • The environment of low/negative interest rates will probably persist for the time being, especially in the Eurozone and Japan. After subtracting inflation, US Treasury yields are also barely adequate, which makes securing regular investment income more important than ever. • Asymmetric monetary policy should continue favouring risky assets in a climate of heightened volatility. Investors should keep an eye on corporate bond yields and, above all, on corporate dividends since with equities investors have a share in real assets. • Dividends have historically dampened the return volatility of equity portfolios. They look promising this year: we estimate that MSCI Europe companies, alone, will distribute EUR 315 billion – a record! Back in 2016, they paid out EUR 302 billion. Emerging market bonds Euro bonds • Credit risk and liquidity premia of Euro investment grade corporate bonds reflect broadly fair valuations, while Euro high yield securities are trading at comparatively expensive levels. • In the US, re-leveraging in the private sector reflects share buy-backs financed by cheap debt, a prospective risk in a rising rate environment. • In terms of historical default rates, US corporate bonds may be slightly overvalued. • Although the arguments for “proper tapering” have meanwhile become more convincing, the Governing Council of the European Central Bank (ECB) will probably not start gradually reducing its asset purchases (“QE”) until 2018 (see also our latest QE Monitor). As such, ECB monetary policy remains extraordinarily loose for the time being. • From an investor’s perspective, the power struggle on the Euro bond markets continues: while the ECB’s negative interest rate policy is keeping yields on short-term debt securities anchored at low levels, the ongoing demand for securities from the Eurosystem continues to exert downward pressure on yields at the longer end, too. However, investors should keep an eye on yield drivers such as increasing inflation expectations, the Fed’s cycle of interest-rate hikes and the expected cessation of quantitative easing – although there probably won’t be a sharp upsurge in yields. • Euro peripheral sovereign markets remain supported by expansionary ECB monetary policy, but are still prone to political risks. International bonds • In March 2017, the US Federal Reserve implemented its third rate hike. The notion that fiscal policy will probably be more expansionary under “Trumponomics”, along with a more • Negative structural factors (e.g. high levels of debt, slower growth potential in numerous emerging markets and protectionist trends in the US) have clouded the secular outlook for EM government bonds. • Moreover, expectations of less expansionary monetary policy in the US over the medium term are weighing on this asset class. In contrast, the economic environment has recently stabilized, albeit not across all countries. • In contrast to many developed markets, local emerging sovereign real yields are on average significantly positive. Corporate bonds Currencies • Overall, the international exchange rate system is still under the influence of diverging monetary policies (e.g. the US rate hike vs. the continuation of low interest rate policies in Europe and Japan) and commodity prices. • The surge in the US Dollar reflects the expectation that the change in the US Administration will lead to an increase in cyclical differences and international interest rate differentials. The prospect of a US economic policy that will focus more on domestic concerns is also putting pressure on emerging market currencies, albeit with significant differences from region to region. • In terms of interest rate differentials, the GBP looks “fairly” valued. In light of the UK’s massive current account deficit and likelihood of dwindling capital inflows, however, Pound Sterling is in danger of weakening further. 3 Allianz Global Investors: Capital Income: Dividends – May 2017 Do you know the other publications of Allianz GI Global Capital Markets & Thematic Research Active Management →→ “It‘s the Economy, Stupid!” →→ The Changing Nature of Equity Markets and the Need for More Active Management →→ Harvesting Risk Premium in Equity Investing →→ Active Management Alternatives →→ Volatility as an Asset Class Financial Repression →→ Shrinking Mountains of Debt →→ QE Monitor →→ Between a Flood of Liquidity and a Drought on the Government Bond Markets →→ Liquidity – The Underestimated Risk →→ Macroprudential policy – Necessary, but not a Panacea Strategy and Investment →→ Equities – The “New Safe Option“ for Portfolios? →→ Dividends instead of Low Interest Rates →→ “QE” – A Starting Signal for Euro Area Investments? Capital Accumulation – Riskmanagement – Multi Asset →→ Smart Risk with Multi-Asset Solutions →→ Sustainably Accumulating Wealth and Capital Income →→ Strategic Asset Allocation in Times of Financial Repression Behavioral Finance →→ Behavioral Risk – Outsmart Yourself! →→ Reining in Lack of Investor Discipline: The Ulysses Strategy →→ Behavioral Finance – Two Minds at Work →→ Behavioral Finance and the Post-Retirement Crises All our publications, analysis and studies can be found on the following webpage: http://www.allianzglobalinvestors.com @AllianzGI_VIEW www.twitter.com/AllianzGI_VIEW Imprint Allianz Global Investors GmbH Bockenheimer Landstraße 42-44 60323 Frankfurt/Main Global Capital Markets & Thematic Research Hans-Jörg Naumer (hjn), Stefan Scheurer (st), Ann-Katrin Petersen (akp) Data origin – if not otherwise noted: Thomson Reuters. Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Investments in smaller companies may be more volatile and less liquid than investments in larger companies. Investments in emerging markets may be more volatile than investments in more developed markets. Dividends are not guaranteed. Bonds are subject to interest rate risk and the credit risk of the issuer. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. 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