Economic data surprising to the upside in Q3

While valuation concerns for equity markets remain in place, recent economic data in the US and eurozone also points to something of a mini-surge in economic momentum over the last 3 months. PMI data has been coming in ahead of expectations and economic surprise indices have turned higher in all regions. During 2017, investors have had to balance their longer-term valuation concerns with generally robust profits growth and improving economic sentiment. While soft data such as PMI indices should not significantly shift portfolio asset allocations, a hiccup before the end of the year is now looking less likely.

Exhibit 1: PMI indices at cyclical highs in US and eurozone

That said, we note that despite the barrage of comments from Fed policymakers reiterating their projection for three US rate increases during 2018, the market is stubbornly resistant to pricing this in. It is a complex picture for equity investors with (no more than) a prospect of US tax reform for 2018 combining with the strong likelihood of rate increases and an ongoing question in terms of the sustainability of current equity valuations and profit margins. In our view, any day of reckoning would however now appear to be postponed until after the end of 2017.

Exhibit 2: Markets still refuse to price in the Fed’s 2018 rate projections

Consequently, in the near-term the balance of risks for 10-year government bond therefore appears skewed to the downside and we would be tactically underweight this asset class at present. In addition to improving economic momentum, we also expect the unwind of the Fed’s balance sheet to place steady upward pressure on bond yields as the supply of longer-dated paper increases. It will be important during 2018 to separate out the effects of quantitative tightening when drawing any inferences from the shape of the US yield curve.

Exhibit 3: Peak confidence? European investor confidence

Furthermore, in Europe as the economic outlook improves the pressure is increasing for the ECB to reduce its level of monetary accommodation. We expect October’s ECB meeting to finally lay out detailed forward guidance in terms of the projected size of the ECB’s balance sheet and it would surprise us if policymakers passed up the opportunity, with European investor confidence higher than at any time outside the 2005-2007 period. We believe a cautious portfolio positioning, with lower than benchmark equity and duration allocations but overweight security specific ideas, remains appropriate.