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MULTI-ASSET - Markets at a crossroads! Be cautious and focus on quality

THE ESSENTIAL

With the cycle ageing further in 2019, markets will become more volatile and remain vulnerable to tightening financial conditions.

Investors will have to reassess their performance expectations, as risk-adjusted returns should be lower.

On one hand, investors will have to look to grasp opportunities that markets, especially on the equity side, offer in this phase, while at the same time being prepared for possible signs of deterioration in the market environment, especially in the second part of the year.

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November 2018

Novembre 2018

The Article

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The economic and financial markets landscape will change in 2019 and the late phase of the cycle will pose multiple challenges. At the macroeconomic level, the global expansion is due to continue, but it will be challenged by higher uncertainty compared with months ago as downside risks have increased. Economic growth should decelerate, but remain above potential in 2019. Inflation dynamics remain skewed to the upside due to higher energy prices and the increasing pressure on wages and compensations. The gobal profit cycle is reaching the peak in some regions such as Japan and the US, as normally happens in a mature phase of the financial cycle, and the inflection point should materialise in H1 19. Profits expectations are more vulnerable as tighter economic and financial conditions could worsen the EPS growth outlook, which though already decelerating remains benign (US EPS growth forecast at +10% in 2019). Key variables for the next reporting seasons will be more in the financial camp: interest rates, credit spreads and dollar dynamics, confirming that financial more than economic conditions will be under watch in 2019. All in all, current indicators, both economic and fundamental, are now more in line with the historical last cycle reference values.

2019: expect lower risk-adjusted returns in a world of stretched valuations and higher volatility

This transition to the next phase of the mature financial cycle will provide an even more challenging environment compared with 2018 in terms of portfolio diversification and risk-adjusted returns. Low carry and low rates in Europe depress the returns potential for conservative Euro based allocations, while current price levels in risky assets already incorporate most profit and economic growth expectations, limiting the possible upside. In general, we expect volatility to remain moderately high and subject to possible episodes of volatility spikes, in line with the trend initiated in 2018. Historically, the mature phase of a financial cycle indicates a turning point regime that is vulnerable to financial conditions, and it usually ends with a bifurcation in two opposite potential outcomes: market correction or market revamp. This time the risk is markedly skewed to the downside, with unprecedented issues, high debt and liquidity and geopolitical tensions. In addition, in absolute terms, valuations on fixed income and equity are stretched, on average. Actual levels, despite the recent correction in equities and higher interest rates, do not provide much value.

Interest rates are expected to move slightly higher while credit spreads should widen; on the other side EPS growth expectations are already partially priced in to the actual levels, meaning a further multiples derating is  likely. From a cross asset perspective, US long-term interest rates above 3% imply the best valuations in relative terms for governments bonds since 2009, which is starting to shift the pendulum marginally from equities to government bonds. Credit is overall less appealing compared with other asset classes, as valuations are tight in IG and HY credit, with some evidence of a outlook deterioration due to tighter financial conditions. Yet in Eurobased assets, carry is still in favour of high quality credit vs govies, thought at a lesser extent than the past six years of asset reflation. Moving on, assessing the liquidity of each asset class will become increasingly relevant, as markets become vulnerable to changes in market sentiment. In this respect, investor positioning and flows will be the key tactical factors to watch. The recent correction cleared some areas of market excess in risky assets and positioning is now less heavy than months ago.

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Seeking opportunities in five main investment themes

No matter the shift or turning point that will materialise, the main themes that investors could exploit in 2019 will be:

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Recalibrate risk allocation as the cycle ages and focus on debt dynamics

A cautious approach to risk allocation will be vital in 2019. Investors on one side will have to seek to grasp opportunities that markets, especially equities, could offer, while at the same time being prepared for possible signs of deterioration in the market environment, especially in the second part of the year. Despite this challenging world with many dilemmas about inflation, trade wars, interest rates, currencies, etc., we believe that a cross asset strategy focused on avoiding areas of excessive debt (public, private and corporate) is a win-win position at this juncture no matter the outcome of the bifurcation; the high bad quality debt asset class will suffer and will be challenged dramatically going forward.

As a consequence, the areas of focus of the cross asset allocation for 2019 will be:

  • Keep a diversified risk exposure and a structural hedge against tail risks;
  • Look dynamically at potential triggers for a shift to a slowdown phase calling for a defensive allocation;
  • A special focus on debt quality at cross asset level, combining low beta/defensive allocation and debt considerations, because it is not necessarily the case that the historically defensive asset classes are the least risky in terms of debt quality this time.
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Amundi Research & Investment Insights Unit
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MULTI-ASSET - Markets at a crossroads! Be cautious and focus on quality
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