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Multi-Asset Portfolios - Top Down Views from Amundi Research

Moving towards a late-cycle financial regime

Central banks’ “beautiful” normalisation of balance sheets and rates will drive the transition from a reflationary into a late financial cycle regime against a backdrop of consolidating growth (from both a macro and micro fundamental standpoint) and subdued inflation. The global economic recovery is not yet complete and accommodative monetary policy is still needed to allow policy implementation, support activity and eventually boost inflation. Benign economic conditions eventually passed through global EPS growth. In 2017, the recovery in global profits has been strong and well spread across regions. Based on our projections, we expect global EPS growth to consolidate around 10% on average. We think that the different stance of the EPS cycle is a good marker for our mid-term equity allocation. In the US, limited pressure on wages has underpinned margins while the dollar’s overall depreciation in 2017 allowed some further momentum in the most recent reporting season. We expect US EPS to post around 10% year-on-year growth (tax reform excluded). The catch-up recovery in European profits will be supported by the expectations of higher rates and curve steepening, benefiting the financial sector in particular. EM earnings will eventually bottom out; Japan is surprising to the upside on tangibly improving fundamentals, independent from the yen (which, however, remains crucial).

In absolute terms, valuation on fixed income and equity are stretched on average. Global markets have, in fact, already priced in a good chunk of economic improvements. Opportunities need to be exploited on a country, style and sector basis to find pockets of value. However, we expect equity multiples to hold firm if the lift in interest rates is smooth and contained, and profits continue to consolidate, as typically occurs during a late financial cycle regime.

The risk premia on IG and HY credit are well above the historical average due to the impressive spread compression and low carry, which should eventually allow some rotation from HY into equity. Unprecedentedly low interest rates are keeping relative value considerations in favour of equities vs govies. On the latter, the extraordinarily low rate environment leaves fixed income vulnerable as the small coupons imply severe initial conditions should a bond bear market start.

Positioning and flows are key tactical factors that will influence and magnify the markets’ correction. At present, while there has been a re-positioning out of global equities, fixed income and high yield in particular are crowded trades.

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December 2017

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Cross asset: expecting lower risk-adjusted returns

As said, we expect a smooth transition from an asset reflation regime towards a late financial cycle. 2018 will be characterised by Central Banks (CBs) progressively removing their excessive accommodation, smoothly reducing global liquidity conditions while maintaining accommodative financing conditions and eventually lower risk-adjusted expected returns. The regime we will move into could be unique and unprecedented for the macro and financial conditions described in the previous pages. As a result, risk/return combinations will be lower than for similar past late cycles  (see the comparison with the “standard” late cycle frontier and the “current” one in the chart). In general, we expect volatility to increase moderately from the current compressed levels, but to remain on average low if liquidity provisions remain adequate.

 

1/ EPS growth 2018 projections

 

2/ Efficient frontiers in different regimes

As a consequence, in order to enhance performance while keeping risk under control, in our view, it will be key to focus on selective opportunities and relative value trades (in preference to directional positioning) within and across asset classes. 

In particular, from a cross asset perspective, fixed income is the asset class with a lower appeal. In fact, the risk attached to it when all our investment spectrum is considered is asymmetric: the expected gradual increase of interest rates will not be offset by coupons that are on average low. For these reasons, it is important that the asset allocation in fixed income is based on regional diversification and flexible duration management. CPI gaps and markets mispricing provide profitable opportunities in the inflation linkers space – in Europe in particular. Moving into the risky assets, a rotation from HY into equity is justified by the risk premium and the valuation reasons mentioned. The carry trade return component supports the case for credit vs govies, particularly where the CB purchasing programme offers good support. US and European companies are at different phases in their respective credit cycles. Our preference is for European investment grade, as there is no evidence so far of re-leveraging of non-financial European companies while leverage in US companies is very high.

 

3/ Amundi risk-on/risk-off indicator

 

On fundamentals and valuation considerations, we favour the equity markets of European countries, Japan and some relevant EM (in Asia in particular). In particular, Europe and the financial sector should benefit from rising interest rates and steepening of the interest rate curve, while Japanese companies should continue to benefit from a weak yen and the BoJ’s equity purchasing programme. The most appealing equity region in EM remains Asia, with some interesting long-term stories based on improving internal and external conditions (China, India, South Korea, to mention the most relevant). At the same time, in such a mature phase of the cycle, an interesting equity theme to play is quality with a focus on potential liquidity issues in an environment of (smoothly) rising interest rates. For the same reasons, another important theme to consider is value in order to diversify regional equity allocation. FX will likely remain the most reactive asset class to CBs and to political noise while some trends are likely to continue (weak GBP, JPY). The USD should be considered for diversification and possibly hedging purposes.

Search for macro hedging

Expected higher volatility, unprecedented fixed income vulnerability, overcrowded fixed income trades, and a potential liquidity drain make the search for hedging a crucial factor in an environment in which inflation and/or rate surprises are flagged as major risks moving forward. 2017 stands as one of the longer lasting “risk on” periods relying on CB support. Moreover, it is worth noting how well balanced the contributions to risk on are at present, both from the real economy and the financial markets (i.e., economic surprises and macro momentum, credit and FX risk premia, safe haven asset class correlations). Moving forward, we expect this to change and more risk on/risk off switches to occur. In fact, during stress events, the interaction among risk factors usually tends to increase and the correlation between asset classes to lift while liquidity dries up. A good historical reference is 2004-2006, when the Fed became less accommodative (see graph below on the evolution of the risk on/risk off indicator).

In such an environment, the risk/reward profile has to be recalibrated, focusing more on limiting potential drawdown mainly through optionality, beyond traditional macro hedges, as they might not necessarily work (ie, the USD over the last year). The risk of twin bear markets involving fixed income and equities with snowballing and painful effects on all financial and capital markets limits the set of potential and traditional hedging strategies and increases the cost of protections at the same time. Consequently, active hedging allocation management is worthwhile in the absence of a real diversifier, such as govies. In our view, liquid hedges, such as gold, and risk-sensitive cross rates, including the AUD/JPY, remain among the most effective macro hedging strategies in terms of costs and benefits.

DEFEND Monica , Head of Strategy, Deputy Head of Research
PORTELLI Lorenzo , Multi-Asset Strategy
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Multi-Asset Portfolios - Top Down Views from Amundi Research
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