High Conviction IdeasMulti-Asset: Geopolitical uncertainty and a maturing financial cycle call for limited directional exposure on risk assets. We see three themes for the next few months: 1) play the last phase of the cycle by focusing on equity markets with stronger earnings growth (US equity) or rotating to value in Europe; 2) play CB (Central Banks) divergences (shorter duration view in the Eurozone, close to neutral in the US); and 3) be selective on EM (positive on China equities vs EM). Hedges remain crucial to try to protect portfolios from overall risk-off situations. Fixed Income: Concerns about trade are preventing yields on core govies from rising. We keep a short duration view (more so in Europe) and we have reduced credit risk, with tighter liquidity ahead. Currency volatility dominates in EM, affecting FX for countries with higher current account deficits. We are cautious on EM bonds in the short term; we see possible entry points opening up in the autumn. Equities: Trade tensions drive divergences in market performances. Earnings per share growth is still strong, especially in the US, our favourite region. However, the cycle is maturing, with diminishing liquidity and rising costs for corporations. The outlook for equity is still overall constructive on a relative basis. But, as volatility is expected to increase, we encourage a cautious approach, with limited risk concentration in specific regions/sectors and a focus on quality and stock picking. Real Assets: In search of additional sources of diversification, on a long-term perspective, energy transition infrastructure is, in our view, a theme to consider. Environment-themed investments have increased considerably in Europe over the past five year. This situation is consistent with the objective of increasing infrastructure spending and pursuing sustainability within a supportive regulatory framework. |
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Risk asset outlook: credit sector and corporate fundamentals are the key variables to monitor.
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Uncertainty over tariff barriers will drag down global trade, but is not expected to endanger global growthTensions on trade have risen a notch: President Trump has explicitly threatened China and Europe with higher tariffs on more products. China and Europe have been accused of not respecting the rules of the game and thus causing the US trade deficit. Even though this argument is not valid, it is unlikely that the US president will abandon his strategy before the mid-term elections. At this stage, the products targeted by tariff increases represent such a small portion of international trade that they should not have an impact on growth. Thus, unsurprisingly, so far, we haven’t seen trade tensions have a significant impact on domestic demand, except for the decline of some business surveys. We keep our macroeconomic scenario unchanged this month (except for an upward revision to inflation in some emerging countries). We expect the continuation of the global expansion, with, however, a slight slowdown in global growth in 2019. Conversely, for the second consecutive month, we have increased the probability of our downside risk scenario (from 20% to 25%) at the expense of the upside risk scenario precisely because of concerns regarding global trade. It is important to note that even in the absence of a global trade war, an uncertain environment can affect trade between countries. We should reiterate that among the identified causes of the slowdown in global trade after the Great Financial Crisis, we note less trade liberalisation compared to the 1990s and 2000s; the rise of non-tariff barriers, particularly in emerging countries; and maturing global value chains. Added to this is uncertainty about the tariff environment, which some studies show tends to have a direct negative impact on trade (based on the higher risk of disruption to global value chains being seen, for instance). In other words, the climate of uncertainty alone is able to slowdown trade. In April – before the announcement of protectionist measures – we observed a significant decline in world trade (-2.4%, 3m/3m, at an annual rate), without there being a clearly identifiable cause. Rising by 3.8% yoy (three-month moving average), world trade is now tending to grow less rapidly than global GDP. As such, even without an outright trade war, international trade (goods) may slow further. Against this backdrop needless to say, domestic demand is more than ever the cornerstone of global economic expansion.
Moody’s spread: yield differential between BAA and AAA, in basis points. |
The economic backdrop is positive, but risks have recently risen: this calls for a neutral exposure to risk assets. |
Risk reduction as markets sail in stormy watersOur central scenario is still for a continuation of global growth and inflation trending mildly higher. So far, there has been a very limited impact on global growth from the announced trade tariffs, and, indeed, the US may actually benefit slightly due to import substitution. However, if a serious escalation were to occur, global trade and financial markets would be hit and no markets would be immune from the effects. We expect the US to be the most resilient area, particularly supported by fiscal expansion. Europe is also expected to grow above trend. However, the main risks are still to the downside and the higher probability attached to the negative scenario could prevent risky assets from showing strong upside trends. In this environment, we believe investors should maintain low directional risk exposure (close to neutrality) and focus on three major themes: 1) last phase of the cycle (selective exposure on equity); 2) CB divergences; and 3) EM winners vs leftovers. High conviction ideasIt is difficult to see a major correction in equity markets as likely when growth is strong and earnings are expected to be good. So, we play the phase of the earnings cycle focusing on equity markets with stronger earnings growth, with a preference for the US, and UK vs European equities. The UK market can benefit from higher oil prices while the industrial components of the EMU index may be impacted by tariffs and lower margins. A rotation towards value (vs the EU market) is another means of taking advantage of recent weakness in the sector. The second theme, CB divergences, is about fixed income and FX. It implies a short duration bias, but with a shorter duration stance in Europe, where yields are still at zero, vs the US, where yields are getting more attractive. We would also exploit opportunities in inflation-linked bonds, as inflation dynamics remain in focus and the market is discounting inflation levels below our expectations. On FX, after the USD rally, most EM CB became more hawkish and divergences appeared within EM FX. We believe that some opportunities have opened up in currencies of countries with strong current account balances vs the USD, mainly in Asia (South Korea, Taiwan, Philippines). The third theme is about identifying EM winners vs leftovers. In a framework of neutrality vs EM assets, we would search for the most valuable relative value opportunities (to temper overall risk exposure), focusing on countries with stronger fundamentals that are less fragile (ie, less external vulnerability). In this respect, we still like Chinese equities vs EM. They could benefit from the transition of the economic model towards domestic consumers. However, we are more cautious on the renminbi. Risks and hedgingThe list of risks is longer: not only structural risks related to possible CB mistakes or to the cycle downturn, but new geopolitical risks due to tariff rhetoric or political changes in Europe (Italy, Spain, Germany) as well as specific idiosyncratic stories in EM could become concerns for investors. Hedging strategies should aim to protect portfolios from risk-off situations, including gold, options on the S&P500, the yen vs the USD/AUD. It is worth also including hedges to specific risks, such as on the credit market (HY), which could be negatively affected in case of liquidity tensions. 
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Focus on credit quality, as conditions become tougher and there may be a contraction in liquidity. |
Low summer liquidity could create price dislocationsOverall assessmentConcerns about an escalation of trade talks into a full-scale trade war are the dominant theme regarding fixed income preventing rates on core govies from reaching new yearly highs and increasing market divergences. Spread widening across the board indicates that the market is starting to price in tighter financial conditions and higher risks on growth. Conditions remain in place for a short duration bias, especially in Europe, where CB normalisation is at an earlier stage. On credit, investors should become more cautious, improving credit quality. In fixed income, keeping a liquidity buffer is also a strategy to consider, especially during the summer season. This could also enable investors to take advantage of liquidity events and consequent price dislocations which could intensify in the next few weeks. DM government bondsThe flight to quality is prevailing on CB normalisation policy effects. In the US, the 10Y T-bond yield is moving in a broad range, down from yearly highs. This is occurring regardless of inflation pressures that are building on both the wage front and regarding costs of goods and commodities, as has been constantly reported in surveys. The pro-cyclical fiscal stimulus increases risks of overheating, and compensation dynamics may accelerate in a non-linear way should unemployment rates decline further. However, due to current rates levels, which are closer to neutral rates, there is a limited scope to remain heavily short duration. The yield curve is expected to remain flat until the Fed further raises rates. In the Eurozone, 10Y Bund yields are close to yearly lows. A mild rebound (not at the 2017 pace) in the Eurozone economy after the 1H18 soft patch (already some signs of stabilisation of business surveys) could again support expectations of higher core rates as soon as trade rhetoric eases. We expect volatility on EU core rates to increase. DM corporate bondsCredit conditions are tougher, with mild spread widening across the board. US corporates are resilient, due to the positive cyclical momentum in the US, but leverage is high. So, we are more prudent regarding highly leveraged names. In the EU, leverage is lower and balance sheets solid, despite the slowdown in revenue growth. We see limited contagion from Italy, thanks to ECB support. Overall, we are more cautious on credit. EM bondsOn the back of USD stabilisation and expectations of significant outflows that have not materialised, EMB spreads recovered from their June peak. At the current level of spreads (EMBI), sovereign debt is not expensive, but market sentiment is fragile, possible downward revisions in growth are expected, and liquidity conditions are poor. We continue to be cautious in the short term, but we see good value for long-term investors to build on recent corrections. In terms of regional allocation, we prefer the Middle East; we are constructive on Central Eastern Europe bottom-up stories, and on Latam over Asia due to valuations. Volatility is likely to remain high over the summer and this could open up opportunities, particularly after elections in Brazil. FX
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Q2 earnings seasons should support equity markets. |
Trade disputes result in market divergencesOverall assessmentWhile US equities have so far been resilient amid escalating trade disputes, the markets that will be most affected by tariffs are under pressure (Europe as a more open economy vs the US; Germany, which is exposed to the auto sector; China and other EM, which are integrated into the international value chain, in Asia; in Latam, commodities exporters). Divergences will remain in place, and eventually increase, supporting the case for active selection. The earnings outlook remains constructive for the time being, and it should continue to support equity in relative terms. The global cyclicals/defensives ratio continues to move in an uptrend for now, but momentum is weaker; should a trade war come into play, this trend could eventually revert. EuropeDespite resilient EPS prospects, investors have become more risk averse, due to ongoing political uncertainty and exposure to external risk (sensitivity to tariffs on cars and to EM, should EM be more affected by tariffs). Without becoming outright defensive, we believe that an additional focus on quality and value is needed to build more resilient portfolios in this phase. At the sector level, we still see opportunities in energy, tech and luxury. United StatesThe Q2 earnings season is at an early stage and we expect very strong results given the backdrop of very healthy fundamentals. The potential drag from tariffs should be limited compared to benefits from fiscal stimulus, as the estimated size of tariffs is about a sixth of the overall expansionary effect on corporations. Margins will be a key area of scrutiny, as some threats could emerge: most companies have signaled confidence in their abilities to get enough pricing to offset raw material cost pressures. But, for the most part, costs are rising faster than companies can raise prices. Another factor to consider is dollar strength: if this continues or even accelerates, it could become a headwind for exporters and international-exposed stocks. As global conditions have become more challenging, we favour a shift to higher quality and lower profit volatility with more staples or staple-like stocks (ie, health care equipment or consumer experience), with low business model volatility. In cyclicals, we prefer energy, banks/credit cards and semiconductors, which provide valuation and fundamental support. Corporate IT spending is another appealing area, as tax reform should favour the modernisation of tech infrastructure and the shift to the cloud, big data and automation. A defensive strategy in this phase is also about reducing risk concentration at sector/stock levels. Emerging Markets
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The green infrastructure market is growing significantly in Europe, but it is important to help investors in overcoming the entry barriers. |
Green infrastructure: a promising innovative marketMoving towards a greener economyOver the two past decades, we have been witnessing strong political momentum to shifting away from a fossil-fuel intensive towards a green economy in Europe (i.e. the French government increased the budget to achieve this goal by 50% in 2017). In this regard, the EU has set ambitious targets to reduce energy consumption and greenhouse gas emissions and diversify the sources of energy supply. However, continuing to foster a greener economy requires cumulative investments in renewable infrastructures. In order to implement the COP21 2030 targets, it has been estimated by the European Commission that the investment gap to fill in is c. EUR 180 billion per year (study dated March 2018). This investment gap is so huge that the public sector cannot support it alone, revealing the key role that the private sector plays in meeting global climate change goals. Given the transition from a ‘black’ to a ‘green’ economy, with the resulting need for increased investment in energy transition infrastructures, the challenge for asset managers is to provide financial solutions that are appealing to their clients as new investment opportunities. The state of the market for green fundsThe energy transition infrastructure market is growing significantly in Europe. Market data reveal investors’ booming interest in green funds, with net inflows having been positive for €32 billion in 2017. Invested assets have increased by 49% in one year and 115% over the past four years. In particular, the bullish trend is being driven by factors that give green funds both more visibility and credibility: 1) the sound performance of the funds in 2017 with an average performance of 10.6%); 2) the gradual diversification of the market offering on both the listed and unlisted sides, with the emergence of green bond products and equity funds, along with private infrastructure funds; and 3) a favorable political environment that, in some countries, has supported a rise in responsible investments (eg, the French Energy and Ecological Transition Act voted in 2015). This strong momentum in the market has made green funds accessible to a far more diversified investor base, both institutional and individual, but it’s still a small drop in the ocean. Challenges and opportunitiesFor now, it appears that green infrastructure investments have not been fully embraced by investors. This may be in part because many investors lack familiarity with this more recent and complex asset class which suffers also from a relative lack of track record vs. traditional investments. Many investors feel they do not have the tool set to evaluate the risks associated with green infrastructure. In this respect, it is important that asset managers are fully committed to helping investors gain a better understanding of and access to this asset class. We think that investments in green infrastructure can provide regular and reliable cash flows, especially when investing in markets that strongly promote responsible investments, like France. In addition, we believe that a greater allocation to green infrastructure can provide diversification benefits, given the low correlation to other asset classes and no relationship with energy and oil markets.
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