Monthly Strategy Report June 2017

Equipo de Estrategia de Mercados de Banca March:

Alejandro Vidal, Unit Director, Market Strategies

Rose Marie Boudeguer, Service Director, Research Services

Pedro Sastre, Service Director, Market Strategies

Sebastián Larraza, Director, Discretionary Management Services

Paulo Gonçalves, Specialist Technician, Research Services

Miriam Ordinas Sanjuán, Specialist Technican, Market Strategies

Joseba Granero, Specialist Technican, Research Services

The positive tone of markets persists

Monthly Strategy Report. June 2017

The positive tone of markets persists

Improvement in the business cycle and corporate profits drive markets.

As we approach the middle of the year, the world’s major stock markets continue to exhibit positive results. In macroeconomic terms, the activity data released reaffirms our scenario that global growth is rebounding. Still more positive is the fact that increased economic dynamism has translated into higher corporate profits. At the conclusion of the Q1 corporate earnings season, results were favourable with profit growth of +14.5% among S&P 500 companies and a ratio of positive surprises of 78%—a clear indication that companies have far exceeded previous expectations.

The outcome of the French election means support for the European project…

In light of the good tone in fundamentals, market uncertainty remains concentrated in economic policy. In May, however, we witnessed a shift as uncertainty drifted out of the eurozone toward other regions. One of the reasons for this was the result of the French presidential election: the victory of the independent, pro-European candidate, Emmanuel Macron—who won 66% of the votes versus 33.9% for the extremist candidate, Marine Le Pen—is expected to provide greater stability to the European project in the near future.

…but political uncertainty remains high worldwide: the US and UK are the focus of attention.

In the United Kingdom, as the 8 June elections approach, polls indicate that the current PM, Theresa May, could fail to achieve her objective of strengthening the majority and may even lose seats. Meanwhile, in the United States, the investigation into the current administration’s alleged obstruction of justice—given its ties to Russia—triggers concern about the stability of sitting president, Donald Trump, and could hamper agreements to adopt fiscal stimulus measures and annual budgets.

The data support a scenario of accelerating growth.

With regard to macroeconomics, as we mentioned, the data remain positive, especially in the eurozone. The region maintained steady growth in Q1, with GDP advancing +0.5% q-o-q. Moreover, with rebounding investment and business confidence indicators at historical highs, the composite PMI reached 56.8 in May, its highest level since 2011.

In the United States, activity data was mixed: Q1 GDP grew +1.2% annualised quarterly and some leading indicators of consumer spending curbed their upswings. In Q1, growth also slowed in the United Kingdom, with GDP advancing a mere +0.2% q-o-q.

The euro appreciates as political tensions recede and activity improves.

The most apparent impact of the trends described—receding political tension in the eurozone and improved growth forecasts for the region—on financial assets was the appreciation of the euro in its main crossovers. The currency market was the first barometer of changing expectations, prompting the euro to appreciate +3.1% against the dollar to exceed 1.12 EUR/USD and +3.7% against the pound sterling to 0.87 EUR/GBP.

The extension of production cuts failed to boost oil prices.

On the commodities market, as expected, OPEC and a dozen non-cartel countries, including Russia and Mexico, agreed to extend the curtailment of crude oil production until March 2018. Despite the announcement, the price of a barrel of Brent fell -2.7% in May because this decision

Monthly Strategy Report. June 2017

had already been partially taken into consideration.

Easing inflation and…

Bond markets continue to appreciate further. Inflation expectations have slowed their recovery with the stabilisation of energy costs. As an example, in the eurozone, CPI eased to +1.4% y-o-y in May from +1.9% previously, with the core rate dipping to +0.9%.

…a cautious approach from the central banks bolsters bonds.

Serving as additional support for bonds is the cautious approach of the main central banks. In the eurozone, the ECB president confirmed a message of greater optimism about economic growth, but reiterated the fact that because core inflation remains low, the economy still needs an accommodative monetary policy to bring inflation closer to ECB targets. In the United States, the Fed minutes indicate that an additional interest-rate hike may loom in June, but the authority has yet to toughen its discourse and has said it would not begin to reduce the balance sheet in the short term.

In this context, the required yields on public debt declined in May: in the United States, the 10-year bond rate fell -5 b.p. to 2.2% and in Germany to 0.3% (-2 b.p.). Peripheral sovereign debt also performed well and in the case of Spain the required 10-year yield fell -10 b.p. to 1.55%, prompting Spain’s government bond index to gain +0.9% in the month.

Credit market gains accelerated...

On the credit market, the global high-yield corporate bond index posted major gains (+0.95%), while the investment-grade equivalent also appreciated +0.2%. For its part, emerging sovereign debt experienced volatility throughout the month, due to the political crisis in Brazil with the launch of a judicial inquiry into sitting president, Michel Temer, after an entrepreneur placed him at the centre of an alleged bribery scandal. Nevertheless, improved activity data in all emerging economies lessened uncertainty and sovereign debt in local currency closed the month with gains of +2%, while the foreign-currency denominated counterpart gained +0.8%.

…and stocks also performed well.

To conclude with equities, the month was positive overall for global stock markets, though performance was mixed according to region: emerging markets saw the biggest gains with the MSCI Emerging Markets index climbing +2.8%, led by Asia (+4.3%), while Latin America lagged behind given declines in the Brazilian stock market (-5.2% in dollars). Among developed countries, the United States performed better, with the S&P 500 up +1.2%, while the Eurostoxx50 closed unchanged. Domestically, the Ibex35 continued its strong appreciation and rose +1.5% in May.

Monthly Strategy Report. June 2017

Strategy for June 2017

ASSET ALLOCATION

Overweighting Neutral Underweight

Shares Cash Bonds

Alternatives

ASSET ALLOCATION

Overweighting Neutral Underweight

EquitiesEurozone Asia

Emerging

Bonds

Emerging debt High-yield corporate debt

Investment-grade corporate debt

Convertible Bonds Sovereign bonds

Alternatives Multi-strategy absolute return Mixed absolute return

Growth accelerates but inflation eases.

Expectations of acceleration in global growth remain intact, but inflation forecasts are easing as energy prices stabilise.

Monetary policy will continue to be more expansionary than expected a few months ago…

In this context, the central banks have reassessed their policies somewhat. According to recent statements, these policies will be more expansionary than expected a few months ago. The Federal Reserve will continue to raise rates, but at a more gradual pace, given that, thus far, leading US economic indicators suggest a growth rate nearer to 2% than the 3% that was estimated after the promise of a substantial fiscal stimulus package from the new US administration. In the eurozone, growth is accelerating, though risks persist—elections in the UK, Brexit negotiations, the possibility of snap elections in Italy—that may increase uncertainty. As such, the ECB has stated that it is necessary to continue stimulating credit to bring inflation closer to target levels and that, for the moment, it has no plans to address the matter of further reducing its bond-buying program or implementing eventual rate hikes.

…which prompts us to make certain changes to the portfolios.

This context of upward growth and easing inflation expectations slightly alters the perception of asset performance in the short and medium term, which leads us to make certain changes to the portfolios.

We have slightly reduced the underweighting of bonds at the expense of monetary assets.

We continue to adhere to the recommendation of overweighting equities, remaining neutral in monetary assets, and underweighting bonds, though we have minimised the underweighting of the latter by increasing exposure to credit at the expense of a slight reduction in monetary assets. The move to reduce liquidity is based on the fact that we do not expect eurozone rate hikes until well into 2018, which will ensure that monetary assets continue to yield near-zero returns.

We continue to recommend investing in short-term bonds…

Along the same lines, short-term rates on the European curve will remain anchored thanks to ECB

Monthly Strategy Report. June 2017

policy, and therefore no significant increases in the yields required on debt are expected, which could reduce the value of the bonds, especially those with short-term maturities, with durations of close to two years.

At the same time, we are in a scenario of yield fluctuations within certain ranges on both the European and US curves, which can be used tactically to increase the advantage of active, flexible bond management.

…and increasing exposure to credit risk.

This context of near-potential growth and moderate inflation also favours credit since it allows companies to retain low financing costs and benefit from higher sales and rising profits, which also drives the credit status of companies upward, prompting upward rating revisions and lowering default rates. Though valuations are very demanding, credit adds extra profitability to bond portfolios.

In short, within the fixed income category, there is potential in short-term high-yield credit, emerging debt, convertible bonds and global fixed income managed actively and flexibly.

After an excellent corporate earnings season, equities have begun to move laterally, awaiting a catalyst to drive them upward again.

After an excellent corporate earnings season, equities have moved laterally in recent weeks as positive factors (good macroeconomics, low rates) are weighed against negative factors (very demanding valuations and few indications of a rebound in the US economy that will reinvigorate other regions). In contrast, there is no risk of strong corrections since investors buy after downswings. This implies that stock markets are waiting for a catalyst to drive them upward again, which could come from additional clarity about the US fiscal and trade policy, the stabilisation of China, and a boost in global trade.

Given the uptrend in corporate profits, we remain optimistic about equities.

In light of the uptrend in corporate profits, we remain optimistic about equities despite less attractive valuations. We continue to prefer European stocks, and with regard to emerging markets, the context is positive for Asian, Emerging European, and Latin American shares, despite political uncertainties, such as those in Brazil.

The risks to this scenario are political and geopolitical.

However, politics remains one of the key risks to markets: the delay of US stimulus, difficult Brexit negotiations, and the uncertainty of Italian politics, coupled with geopolitical tensions in the Middle East and the Korean Peninsula, may discourage investors.

The dollar may strengthen as the FED raises rates, but its potential is waning.

On the currency market, the dollar was hit by setbacks in macroeconomic data, the absence of the announced stimulus measures, easing inflation, and expectations of a further rate hike. Nevertheless, as the Fed raises rates, we expect the dollar to return to the 1.05-1.10 EUR/USD range. Although the upside potential is not excessive, we still recommend keeping dollars in the portfolio for diversification purposes.

We expect oil to remain around $50/barrel.

As for oil, we expect prices will remain near $50/barrel of Brent in the short-medium term, a level that generates stability for both exporting countries and consumers.

Monthly Strategy Report. June 2017

Equity Indices IBEX35 (3 years)

Euribor Euribor 12 months (3 years)

EUR/USD (3 years)

10 years government yields

Currencies

Government Bonds

Corporate Bonds (1 year spread)

Commodities

Data: Bloomberg

Monthly Strategy Report. June 2017

Equity Indices performance (3 years)

Monthly Strategy Report. June 2017

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