High Conviction Ideas
Multi-asset: We are neutral on risk assets due to rising uncertainties. In equity, we maintain a preference for the US, with limited exposure to Europe (basic materials), the UK, and Japan. We are cautious on EM. In fixed income and FX, we still play CB divergences with limited duration and inflation-linkers. We are very cautious on credit. Hedges are still in place in case of a deterioration of the current scenario.
Fixed income: We don’t think CBs will change their plans due to idiosyncratic stories, even if spillovers are visible (flows into core bonds and a sell-off of fixed income risk assets), we remain cautious on duration (shorter in Europe than the US), and we have raised our credit quality/liquidity focus. The USD should remain strong in the short term, but most of the appreciation is behind us. Through the year end, this could give some relief to EM assets, currently under pressure.
Equities: We favour strategies to deal with a maturing phase of the market and we focus on quality, less leveraged companies, a reduction in stock/sector concentration risks and a balanced approach between cyclical and defensive sectors. It is not time yet to become outright defensive, in our view, as the earnings outlook is still constructive. However, volatility should trend higher due to trade noise, the approaching US mid-term elections, idiosyncratic stories and tighter financial conditions. We still favour the US market given its superior earnings growth.
Real assets: With lower returns expected ahead for most traditional asset classes, investors should continue to search for sound risk/return potential as well as diversification benefits. In this respect, private debt solutions, especiallythose focused on the most senior and secure parts of capital structures, could represent attractive ways to complement traditional fixed income exposure.
Volatility on BTPs will remain elevated until September, when there will be more clarity on budget law.
Global growth: still decent but multiple risks ahead
The year began with a synchronised global recovery as most economies benefited from a buoyant environment. The risk of inflation and CB mistakes dominated investors’ fears. Since the spring, clouds have accumulated globally. The second half began under less happy auspices than the first, with a less buoyant economic climate and many risk hotspots. On the one hand, growth in the Eurozone was weaker than expected in H1 (after a strong second half of 2017). On the other hand, large EM have seen their macrofinancial situation deteriorate with the USD appreciation, which puts countries where private sector debt is denominated in USD into strong difficulty. For example, Argentina and Turkey are in crisis today. These are idiosyncratic shocks that in theory, should not spread. However, many EM were distrusted by investors during the summer. In addition, Donald Trump’s protectionist threats have multiplied. The proximity of the mid-term elections (6 November) is encouraging him to implement his promises of the presidential campaign on trade. Europe has been relatively spared for the moment, but in view of Donald Trump's recent statements, one cannot rule out taxation on auto imports. That said, for now, China remains the subject of the most aggressive protectionist measures.
Added to the threats of a trade war are risks of very different nature:
• US sanctions on Iran, which tend to drive up oil price.
• The fiscal slippage in Italy. Relations are tense in the coalition government on what strategy to follow and the size of the budget deficit (see box below).
• Brexit negotiations are stalling and governments (in the UK and in the rest of the EU) are openly preparing contingency plans in case of no agreement by 31 March 2019 (hard Brexit).
• The Turkish financial crisis may get even worse (we anticipate a recession in the coming quarters).
The multiplication of risks increases global uncertainty. If we continue to anticipate further global expansion, it is at a slightly slower pace in the Eurozone, China and, on average, in EM. The US economy, for its part, remains supported by fiscal policy, the effect of which is expected to weaken in 2019. The risks to growth are clearly on the downside over the next 18 months. As for the upside risk to inflation, without having disappeared, it has weakened (except of course in countries where the currency has fallen). Inflation is a lagging indicator of activity; an inflationary surprise would be short-lived if, as we believe, the world economy slows down.
BTP= Buoni Poliennali del Tesoro, Italian government bonds.
We continue to prefer relative value themes and to focus on solid fundamentals to better navigate uncertain waters.
Cautious and selective
Asset class returns have been mixed this year to date: the persistently robust growth in the US has allowed the equity bull market to continue, posting a 20% EPS growth. Performance has been poor for EMs, as investor sentiment deteriorated on the back of a stronger dollar and higher US rates. Countries more dependent on external financing saw the value of their currencies fall. China suffered the tariff threat from the US administration; particularly weak was the IT/technology sector in Asia. Our central scenario is still for a continuation of this phase leading to a late cycle, global solid growth but we see it decelerating as inflation trends mildly higher, with risks tilted on the downside. We expect CBs to stick to their path of very gradually normalising monetary policy in this relatively favourable macroeconomic outlook. Global trade tensions are set to continue and idiosyncratic issues (such as the crisis in Turkey) will emerge more frequently as the liquidity in the system deteriorates and financial conditions get slightly tighter. We continue to prefer relative value stories and themes rather than directional exposures and we continue to focus on solid fundamentals to better navigate uncertain waters.
High conviction ideas
From a cross-asset market perspective, we stay close to neutrality on global equities, consistent with the idea of being in a mature financial cycle. It is difficult to see a major correction in equity markets when growth is strong and earnings are good (we anticipate that the US Q2 & Q3 earnings seasons will be good), though positioning is beginning to be a worry, with holdings of US equities close to all-time highs. Investors should play themes that we like to call “the last race for risk assets”, focusing on equity markets with stronger earnings growth, with a preference for US and UK equities versus European names. We favour a rotation to value in Europe, with a preference for value stocks versus the EMU index. In fixed income, we look for value in the theme centred on CBs’ asynchronies. We have a defensive approach on the German short end of the curve and UK real rates; we have a neutral view on US duration; and we are cautiously positive on corporate IG and inflation-linked bonds (10Y US, EUR, JPY and US 2/10 inflation steepener). We have systematically trimmed our preference for credit. While we keep a neutral view on EM (both equity and bond), identifying “EM winners versus leftovers” remains one of our main themes. We search for the most valuable relative value opportunities, focusing on countries with stronger fundamentals and less external vulnerabilities. We prefer China to the global EM from a positive medium-term perspective. Overall, we consider EM valuations attractive but we prefer to look for entry points after the US mid-term elections, when we expect some easing of trade tensions and when most of the electoral events in EM should be over.
Risks and hedging
Idiosyncratic stories support core bonds. .
Core appeal, but not time to be overly defensive
The appeal for core bonds continues due to both the geopolitical tensions and erupting idiosyncratic stories in EM. The Turkish crisis is the latest in signalling that conditions have become tougher for EM debt. Selectivity is increasingly the name of the game to limit the effects of country-specific vulnerabilities and imbalances. As the tide that lifts all boats, notably ultra-accommodative monetary policy, is approaching an end and financial conditions become tighter, investors should continue to explore opportunities in credit, but with a more cautious attitude in the areas of the market that benefit most from the buyers of last resort (CBs), notably low quality/low liquidity bonds. We are still cautious on duration, but, especially in the US, investors should consider reducing their shorts as we move closer to a neutral rate.
DM government bonds
The 10Y German bond yield remains anchored to year-to-date lows, benefiting from the flight to quality effect as a response to the Turkish crisis (with a potential impact on European banks) and tensions on Italian govies. The next weeks will be critical for the Italian budget law and noise will remain high. The Italy-Spain spread being close to historical peaks means markets are confident about the ECB’s toolkit to reduce contagion risk. We don’t believe that these frictions will impact on the ECB’s announced plans. Eurozone CPI is close to the CB’s target and economic conditions remain sound, despite some challenges. Hence, in the tug of war of idiosyncratic stories and sound economic conditions, we expect core rates to remain in the current trading range.
DM corporate bonds
We have taken a more conservative and selective approach on credit in recent months, even if we do not think it is yet time to be too defensive. Investors have started to price in a peak of global economic activity, less supportive technical conditions and diverging fundamentals between the US and Europe. EU companies continue to be very cautious, with low leverage and high cash ratios. US companies remain confident in the economic cycle, increasing leverage and decreasing their cash ratios.
We remain prudent at the moment, as some political noise is expected ahead of Brazilian elections in October. Our preference is for hard currency bonds over local currencies due to valuations, the risk-off environment and EM FX fragilities versus the USD. Our favourite picks are Mexico (agreement with US on trade and attractive risk/return profile in local currencies (LC) sovereign debt), Serbia (good fundamentals and appealing risk/reward) and Argentina (after the IMF support). We are cautious on Turkey (LC) .We don’t expect US sanctions on Russian sovereign debt, but volatility will remain high. Through the year-end, when we expect easing trade tensions and a stabilisation of the USD, EM bonds will be back in focus, with attractive yield premiums for long-term investors.
The USD should remain well supported in the short term versus main currencies thanks to the US economy’s strength and CB divergences. However, US elections in November could weigh on the greenback, giving some relief to EM FX.
Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate the economy by buying financial assets from commercial banks and other financial institutions.
US earnings supremacy continues.
Strong earnings season
Divergences have increased as a consequence of idiosyncratic stories (the Turkish crisis weighed on the EU market, but also EM were strongly hit by the risk-off mood), while the US market is re-approaching historical highs. Earnings are up, also owing to strong growth. Divergences should remain in place in the coming months, softening next year when some of the one-off US EPS growth will be over. For Q3 and Q4, the earnings outlook is constructive for global equities in the context of sound growth, modest rises in interest rates and barring an escalation of the trade dispute into a trade war. The US continues to be our favourite market due to the strong EPS growth premium and improving relative valuations (thanks to EPS growth). As the cycle matures, (higher oil prices and input costs), stock picking will remain crucial, with a preference for quality, less leveraged, companies.
The outlook remains moderately positive, but with some vulnerabilities. The Turkish crisis could impact EU banks, which have around 150 billion of USD in Turkey. Even if this is not a problem for their balance sheets, from a P&L perspective a jump in provisioning could dent their results and affect MSCI Europe EPS growth. The recent weakness of the EUR/USD is supportive, but this tailwind should prove temporary (until Q1 2019). In trade weighted terms, the depreciation versus the USD was balanced by an appreciation versus EM currencies.
The US market is enjoying one of the longest bull markets in history, but this is not enough to call for an imminent turning point. The economy is growing nicely, small business optimism is solidly close to an all-time high and capex plans are solid. The earnings boom incorporates the tax reforms effect, which added about 8% to this year’s EPS growth. The outlook for earnings is still positive for 2018 and 2019. However, we believe that a “quality check” to the portfolios is warranted at this stage, as well as the implementation of more defensive strategies (such as reduced stock/sector concentration or increased focus on valuations and lower volatility). This year most of the S&P’s performance is explained by a few sectors (IT, consumer discretionary and energy) and the breadth of the market is decreasing. Areas we view as needing attention are the IT sector, which is exposed to possible retaliation measures just when the growth/value ratio is stretched globally, the strong USD appreciation, which could hurt more global exporters, and the near flat yield curve. Approaching the US mid-term elections, we expect some political noise, but an overall positive backdrop.
The recent sell-off improved valuations and, if there is no more negative news on the growth side, EM equity could rebound a bit from its depressed levels. In the last quarter, we revised downwards EM EPS forecasts to a range of 5-9% (versus the previous 6-11%) for FY2018 and we are more conservative than the consensus. We remain prudent on the asset class, with some challenges ahead. World trade growth is set to decelerate for 2018 as well as EM exports, idiosyncratic political uncertainty is high (Brazil/South Africa/Turkey) and there is uncertainty on US policies. On the positive side, we see the commodity outlook as favourable. As investment ideas, we like Greece and oil-related themes. We are also positive on China as most of the concerns on economic slowdown or on trade tensions seem to be priced in, valuations are very compelling, and we see policy reaction supporting the economy.
The European private debt market is set to offer compelling opportunities over the coming year, but deep expertise is needed to exploit them.
Private debt: diversified strategies to invest in Europe
A fast-growing market in Europe
The European private debt market has expanded significantly over the last 10 years. According to Preqin’s Private Debt Quarterly Update (Q2 2018), while the largest proportion of private debt fund activity has occurred in North America over the past year, the European market has seen the largest gross growth rate (Q2 2018 aggregate capital target increased by 52% versus Q2 2017). This trend is being fuelled, in particular, by the increased adoption of non-bank lending. Disintermediation is clearly intensifying in Europe, with the proportion of private debt-backed deals in the region gaining traction steadily over time. Across Europe, after the UK, France and Germany were the second and third most disintermediated markets in terms of deals in 2017. Nonetheless, many investors are looking to the European private debt market with increasing attention and interest given the sound risk-return potential, as well as the diversification benefits it may offer their portfolios. Overall, European issuers want to diversify their funding sources and arrangements, while investors are looking for increased yields and diversification. We expect this to be a long-term trend and thus expect the European private debt market to see strong growth and offer compelling opportunities over the coming years.
Watch out for opportunities
We firmly believe that this asset class can no longer be ignored in strategic diversified allocations.
We are convinced that investing in the most secure and senior part of capital structures can provide downside protection against a possible turnaround in the credit cycle, while offering attractive long-term returns. In addition, we favour floating rate assets as they can help to protect portfolios from rising interest rates and offer a relatively attractive yield. Finally, we think that portfolios need to be modelled with an optimal allocation to liquid and illiquid assets, and a strong complementarity with traditional fixed income.