As 2018 gets under way, we are entering a phase of expansion in the economic cycle. This is especially clear in North America and, to a lesser extent, in Europe.
By Yoann Ignatiew and Xavier de Laforcade of Rothschild Asset Management
In North America, our scenario of rate hikes has arisen. We nonetheless remain alert to the pace of increase. If the Fed sticks with its initial pace, we anticipate a correction in equity markets. A steep acceleration in inflation, for example, could push U.S. monetary policy in this direction. However, we do not adhere to this scenario and still believe that the market could bear higher interest rates, thanks to robust and well synchronized economic growth.
As a result, the US equity markets continued to rally during the quarter and, despite the maturity of the economic cycle, they should benefit from the Trump Administration’s «tax break». This measure will without a doubt have direct repercussions on earnings growth. Meanwhile, a second round effect could appear as consumers will have higher wages and exceptional bonuses.
Favourable Environment
Two other factors are also likely to have a positive impact on the U.S. economy. The first is the upturn in capital expenditure, a variable that is closely correlated to the U.S. market, and the second is the dollar’s weakness, which is already benefiting to export-intensive companies.
Canada is also riding robust growth, driven by strong domestic demand, a booming real-estate market, and a rally in energy and commodities. Not to mention that the unemployment rate is at a 50-year low. This favourable environment has allowed Canada, in turn, to trigger the normalisation of its monetary policy with three rate hikes, as in the United States. This trend is expected to continue into 2018.
Emerging Markets Driven by China
Emerging markets will still continue to be driven by China this year. The Middle Kingdom is expected to maintain solid growth but without the exceptional levels of 2017. Its momentum will nonetheless remain closely dependent on domestic consumption. Interestingly, since the 19th Communist Party Congress, the fight against pollution has been stepped up, with the closing of excess capacities in the mining and industrial sectors.
Meanwhile, tax breaks on «clean» products, such as electrical vehicles, have been granted, thus underlining the government’s determination to promote the innovation capacity of the Chinese technology sector and to benefit from the heavy domestic demand.
As the year begins the good surprise is from Europe, where we are seeing a cycle upturn, driven by growth in the U.S. and Asia. We are seeing a blend of rising domestic demand, a significant reduction in unemployment in some North European countries, and a still-mixed picture in southern Europe.
Maintain Moderate Exposure to Equities
In terms of allocation, R Valor currently consists of forty-two stocks. Given the equity rally, the maturity in the cycle and the macroeconomic environment, we are sticking to our moderate exposure to the equity markets, at 75 percent to 80 percent of fund NAV. Incidentally, we made almost no change to our equities weighting during the quarter, as they continue to offer yields significantly higher than bonds.
For the past six months we have been advocating for higher exposure to cyclical sectors. In particular, we have invested in North American financial stocks, by raising our weighting in insurance, as well as energy sector. Part of our investments was focused on this theme during the half-year.
We do not expect oil to rise above $70/bbl. for long but are convinced that the stocks we have selected are undervalued given their cash-flow generation potential. We increased our weightings in U.S. companies, mainly those active in the Permian basin, such as Concho Resources or Halliburton, due to their positive correlation to an increasing domestic output.
Higher Exposure to Cyclical Sectors
Even so, we have not neglected defensive sectors. Mining is highly representative of this dual approach. On the cyclical side, we forecast higher prices of commodities such as copper, zinc, and metallurgical coal, due to the reduction in production capacities over the past two or three years and a recovery in capital expenditure. So we felt it made sense to increase our positions in companies linked to production of these ores, such as Teck Resources and Ivanhoe Mines.
Our approach is more defensive on gold mining but is based on the same analysis. And there is an even greater imbalance between supply and demand. Indeed, we have seen a clear decline in output, despite continued heavy demand, driven by consumption in the jewellery sector and the emergence of new consumers, mainly from Asia.
Promising New Sources of Growth
So we feel actually these stocks are clearly below their potential and attractively valuated in regard to the gold price and to their cash generation potential over the next two years. Accordingly we therefore upped our exposure to Goldcorp and Pretium Resources.
Lastly, we recently expanded our weightings in the healthcare sector, focusing on themes such as the ageing of the population and oncology research, with AstraZeneca being added to the portfolio. Healthcare is a sector currently underweighted by investors that suffered from serious corrections in 2014 due to fears over the repeal of Obamacare and pressures on drug prices.
Recent investments nonetheless offer promising new sources of growth. We see this theme as a relatively defensive long-term stance, while also taking advantage of historically attractive valuations.
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Portfolio’s characteristics as of 31/01/2018. These characteristics are not static and may evolve over time.
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