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European funds still hungry for euro zone assets, eye inflation risk

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European funds still hungry for euro zone assets, eye inflation risk

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By Claire Milhench

LONDON (Reuters) – European fund managers raised their euro zone equity exposure to three-month highs in December, cheered by growth even if many fear that an ongoing inflation pick-up could lead to more hawkish central bank policy next year.

A Reuters monthly asset allocation poll of 19 European fund managers showed that euro zone equity holdings rose to 30.4 percent, the highest level since September.

Overall, investors slightly increased their equity holdings to 45.3 percent of global balanced portfolios, while cutting cash to 5.7 percent, the lowest level since at least January 2013.

Cedric Baron, head of multi-asset management at Generali Investments, said he had a “long bias” to euro zone equities, based on improving economic fundamentals.

“Capex has clearly been the major missing element to support economic growth, but thanks to a much more positive sentiment from corporates, it’s picking up significantly and should support the labour market and, in turn, growth,” he said.

The euro zone economy likely expanded by 0.8 percent in the fourth quarter, according to IHS Markit. That would be the strongest official quarterly growth rate since early 2015. Meanwhile, consumer inflation in the bloc rose to 1.5 percent in November.

Poll participants also raised their allocations to European bonds by almost 4 percentage points to 56.2 percent on average, a four-month high. This was possibly a reflection of the fact that the survey was conducted from Dec. 14 to 20, just after the European Central Bank’s (ECB) meeting.

The ECB stuck to its pledge to continue asset purchases for as long as necessary, despite better growth and inflation forecasts.

However, two-thirds of poll participants who answered a question on the ECB expect it to have finished buying by the end of 2018.

Raphael Gallardo, a strategist at Natixis Asset Management, highlighted the shortage of purchasable German bonds, and a growing perception among the ECB’s governing council members that the benefits of quantitative easing were diminishing while the costs are rising.

“The significant reduction in output gaps across the euro zone likely paves the way for the emergence of self-sustaining inflation dynamics by the end of 2018,” added Peter van der Welle, a strategist at Robeco.

INFLATIONRISK

But it was the risk of a sharp rise in inflation that troubled investors the most.

In December, the Fed raised interest rates for the third time this year but left unchanged its forecast for three more rate increases each in 2018 and 2019.

Not surprisingly then, an overwhelming 85 percent of poll participants who answered a question on the Fed expected it to raise rates three times in 2018 – although some noted that the market seemed to be questioning the Fed’s resolve.

“A full hike is not priced until June 2018, and a second hike by December is priced with a 70 percent probability only,” said Jan Bopp, an asset allocation strategist at J Safra Sarasin.

Generali’s Baron also noted this mismatch, highlighting it as one of the risks for 2018. “While we forecast three hikes for next year, we think the Fed could surprise investors with a further hike should growth remain solid and inflation accelerate more than expected,” he said.

Investors cut holdings of U.S. bonds to 17.4 percent of their debt portfolios, the lowest level since February 2015.

Within their global equity portfolios, managers slightly trimmed U.S. exposure to 37.4 percent and cut emerging equities to 15.9 percent from 16.5 percent.

Both have had strong runs, with U.S. stocks <.SPX> making record highs, up almost 20 percent year-to-date, whilst emerging equities <.MSCIEF> have returned just over 31 percent.

(Reporting by Claire Milhench and Maria Pia Quaglia; Editing by Hugh Lawson)

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