Tactical Asset Allocation 2013 02 13

We sell GEM equities but remain o/w equities by 5pp. Our bias is to reduce risk further. We introduce a new benchmark portfolio with open currency risk in equities. We are u/w Japan, o/w Europe. We still prefer High Yield within corporate credit and establish an overweight of EMD (local) vs EMD (hard).

The acceleration of the global economy is moderating and the recent strong performance of risky asset is making near-term risk/reward less attractive. Therefore we reduce our exposure to risky assets by selling equities. We do not expect a severe slowdown in growth nor do we expect a strong pullback in equities at this point, but the case for an aggressive overweight to risk is less obvious to us.
 
The global economy continues to recover. Late 2012 growth re-accelerated, among others driven by credit-induced growth in China. Activity in the property sector picked up and spilled over to the broader economy as indicated by the strong upward trend in the monthly PMI figures. However, we do not expect the Chinese economy to accelerate further. We think it operates close to its production capacity and that Beijing will not repeat its policy failures of 2009 by overheating the economy once more. Given extreme credit creation lately we now expect the authorities to put an end to the credit stimulus and start tightening policy fairly soon (as highlighted as a potential risk in the December TAA publication). As a consequence we remove our positive bias towards EM intra equities.
 
The intensity of the European debt crisis continues to fade, but risks still exist. Mario Draghi has argued that financial markets looked less fragmented and that conjunctural indicators had stabilized. We, too, are constructive on the Euro Zone. We think that domestic private demand will recover moderately in 2013. Currently, this is not what we are observing though. Bank lending remains tight and private investment is still depressed. But in the ECB Bank Lending Survey European banks indicate that the economic outlook and not capital or funding issues are holding credit growth back. Therefore, when banks start to see a brighter future they will be willing to supply the needed credit. Lately, PMIs have not only stabilized but started to increase although from a very low level. The business outlook is thus improving and corporate appetite for investment will grow. In that scenario it is highly likely that credit will be available given the message in the Bank Lending Survey. We thus still expect a return to growth in the more cyclical parts of the euro area economy later this year. However, one should be careful not to become too positive on the region. Fiscal repair is still the dominating theme and fiscal policy will stay tight throughout the year. In sum we expect the Euro Zone to move out of recessionary territory in the first half of the year and growth to be moderately positive in the second half.   
 
The latest job report demonstrated that the US economy is solid. Not so much because of the 157,000 new jobs that were added to the economy in January, but because of the upward revision to 2012, where almost 700,000 more jobs were added to the private sector compared to the first published estimate. Other important data support a positive view. The ISM increased in January and initial jobless claims are back to (slightly lower) levels from before Hurricane Sandy. Furthermore, the housing market continues to improve and will boost private sector spending in 2013. Finally the US Q1 Senior Loan Officer was fine, though not a game changer to us. Fiscal policy will be the main headwind this year. The tax compromise in early January meant that the fiscal cliff was dodged this time around, but Congress still needs to agree on what to do about the spending side of fiscal policy. Consumers already face higher taxes and if some parts – or even worse – the whole of the sequester is implemented, we expect a significant drag on growth. So it seems as if the key determinant of US growth momentum will be the battle between fiscal-policy tightening and housing-market recovery. We stick to the view that a tight fiscal policy harms growth more than most would expect when growth is slow. Even though we, too, appreciate the ongoing rebound in US housing we do not expect above trend growth yet and we do not find it unrealistic for the US economy to decelerate in the near term.    
 
All in all, the outlook seems moderately accommodative for risky assets. However, with the recent strong performance by risky assets, the market is more vulnerable to negative shocks. Therefore we adjust the portfolio tactically to align risk and reward – in other words, we want to be paid well when taking on risk. If the market performs strongly in the coming weeks we expect to sell risky assets once again. To add more risk we would probably need to see a strong turnaround in the European credit cycle, but of course we never pre-commit.