Yves, things are certainly heating up in international trade. We've seen that President Trump has announced tariffs on steel and aluminium. How do you think this is going to play out?
Yves Bonzon: First of all, I think this came as only half a surprise because Donald Trump had alluded to the potential for trade discussions early on – even before he was elected, in fact. The market reacted negatively, and rightly so for a variety of reasons.
Above all, I think this issue is unlikely to go away any time soon. One of the important things that the US President said – or tweeted – is that trade wars are good wars because they are easy to win. I'm going to remember this and listen carefully to his words here because I think it means that he wants indeed to engage with the trade partners.
It's going to be an on-and-off process of negotiations and threats. The US has a deficit and the world economy needs the US to have a deficit to provide dollars to the rest of the world. Those countries that have a surplus have probably more to lose and are likely to make concessions over time.
But don't you think this is a very dangerous game the US is playing? Do you think it will pay off in the long run?
If worst comes to worst, it will indeed be a very important issue for the markets. And the reason for this lies in the profitability of the S&P 500 Index. Most global US companies have tremendously benefited from globalisation in the past two decades, essentially by offshoring their value chain. And that ability to offshore the value chain is fundamentally and to a large extent dependent on free trade.
So there is a very negative feedback loop effect if trade barriers are going to be increased because inevitably, this will structurally affect the profitability of US corporations.
Now, delving into financial markets in a bit more detail, it looks like market volatility is going to continue, so what can we expect from financial markets?
We have recently written about peak asset inflation. This is the idea that, in the context of a synchronised recovery, policy makers have a strong incentive to slowly pull the plug on stimulus, especially monetary stimulus. As we also commented, this is a bit odd because this quantitative tightening is happening at a time when the fiscal policy lever is being activated, and potentially in a significant manner when it comes to the US. So that combination of fiscal stimulus and quantitative tightening could prove very toxic for the bond market.
In addition to this, we have witnessed acceleration in the rise of US dollar funding costs in recent months. The LIBOR has increased, and the extra spread on interbank funding has also increased substantially. And this triggers two phenomena: one is that leveraged fixed-income investors are increasingly priced out by the rise in their funding costs. Also, the transatlantic carry trade is no longer profitable. In other words, the cost of hedging dollar assets back into a European currency is becoming prohibitive.
Interestingly enough, this has affected mostly the higher-quality assets, and to a much lesser extent the lower-quality assets because they still have a yield pick-up carry that makes the economics of such a trade work. But should this trend continue – and this, by the way, is the indication that the Federal Reserve shared with market participants in its FOMC statement of 21 March – and if the Fed continues to hike interest rates in a quasi-mechanical manner, it will only make matters worse, potentially spreading to lower-quality assets. These are the headwinds that investors will continue to struggle with in the coming months.
So, given the current environment, what should we keep in mind when it comes to asset allocation?
We don't have any signs of a recession in the foreseeable future. Therefore we will not take radical action and dramatically reduce risky assets in the portfolio. But what we have done is essentially two things: first, we have improved the liquidity profile of the portfolio. So far it hasn't helped us a lot because, oddly enough, safe-haven bonds have barely reacted up to this point. But when times get really tough, we expect them to eventually play their defensive role in the portfolio. Improving the liquidity profile is important because liquidity could very quickly vanish from other assets that are not traded on organised markets. Second, we have marginally reduced equities, but more importantly, we really focus the equity buckets on those segments that we feel have the best profile at this point in the cycle. Because we see market breadth narrowing, that is, advances becoming increasingly narrow.