With recession unlikely in the near future, markets will be driven mainly by political developments and CB actions.
Global trade contracted sharply in 4Q18 (-3.6% annual rate). This contraction partly represents a return to the “more normal” levels set after the great financial crisis of 2008, while 2017 was just an abnormally high year. In fact, while the annual growth rate in global trade was around 6% in the period 1992-2007, this has moved down to around 2.6% since 2012 (while 2017 was very high at 5% annual growth). That said, the contraction in trade seen at the end of 2018 proved to be particularly extreme: indeed global trade was down by -1.4% yoy in December, a contraction unseen since 2009. In part, this could be due to the high level of uncertainty. In fact, in response to an uncertainty shock, firms potentially adjust their inventory policies by making disproportionately large cuts to their orders of foreign intermediates. If this is true, the soaring uncertainty induced by the fear of an escalation in the trade war between the US and China (uncertainty indices peaked in December) may explain the sharp fall in trade in the same month. Political uncertainty dropped in January, probably because of the perceived potential for an agreement being struck between the US and China. It is likely that uncertainty will fall further in February, which, ceteris paribus, could help world trade to stabilise.
However, other elements of uncertainty persist, especially in the short term in Europe. On the one hand, the risks around Brexit remains high, while on the other hand, Donald Trump may want to increase pressure on Europe by "demanding" measures to rebalance bilateral trade between the US and the Eurozone (with the automotive sector in focus). These issues could prove to be problematic, given the recent weakness in the Eurozone.
It is in this context that central banks have changed their communications:
Ultimately, support from central banks tends to reinforce our scenario: the shock should prove temporary, with domestic demand expected to remain solid (especially consumption) on both sides of the Atlantic.
The Strategist’s View - Credit and peripheral bonds in demand
Peripheral bonds: January saw quite strong and successful new issuance activity on the part of the Italian Treasury, as Italy accounted for roughly 16% of overall gross issuance and 78% net issuance for the whole year: other peripheral countries were successful too in placing new debt. February started with another successful, oversubscribed, 30Y deal, but weighting in the secondary market, while the macro picture remains challenging.
Credit: January also saw one of the best monthly performance of the last years for both US and EUR HY, with most of the ground lost in Q4 being recovered. Technicals turned more supportive for EU spread products as: 1) the ECB turned dovish and is likely to deliver a new round of long term operations; 2) the fall in safe haven bond yields increased the relative attractiveness of spread products; 3) the search for yield should persist, especially in the 1-5Y, where 75% of debt has negative or flat yield to maturity; 4) positioning was quite light at the start of the year and inflows were back. The other side of the coin is that valuations now look to be more in line with fair values (though still attractive vs quite low equity implied volatility) while the macro slowdown intensified in the Eurozone.
A consolidation phase and a more carry-like return by spread products may now be expected on the back of recent strong tightening, less compelling valuations, and persisting economic slowdown. Short-term drivers are likely represented by developments on the political side together with the next steps in monetary policy to be taken by the ECB and the Fed.
* The targeted longer-term refinancing operations (TLTROs) are Eurosystem operations that provide financing to credit institutions for a predefined period of time. They offer long-term funding at attractive conditions to banks in order to further ease private sector credit conditions and stimulate bank lending to the real economy.
DM= Developed Markets, EM = Emerging Markets, CB= Central Bank, ECB= European Central Bank, Fed= Federal Reserve.
Given the fragile balance at play, it is time to stay vigilant, take profit in areas that have already outperformed and look for further entry points.
The strong bounce experienced by risk assets which followed the December meltdown has reduced many valuations gaps and stretched oversold conditions. We wonder if the rally is sustainable. We believe this is not the time for chasing the bulls but rather for being selective and vigilant, taking profit where the rebound has already materialised and getting ready to re-enter in areas where the repricing has not fully occurred yet. Our central case is for a decent but decelerating global economic growth, with slowing profit growth. Plus, there is a combination of high geopolitical risks and a number of idiosyncratic risks, which increase the uncertainty on the policy reaction front. These factors are today tamed by the more dovish attitudes of CBs, which will help to further extend the late cycle, and will allow the persistence of favourable conditions for selected risk assets (credit, selected EM stories). Given the fragile balance at play, we would stress the need to be vigilant, in a framework of cautious optimism.
High conviction ideas
Global profit cycle has passed the peak although we still expect single digit growth in 2019. Revenues will be a key factor regarding global equity returns performance. We prefer to keep an overall defensive bias, with a focus on diversification among regional equities, and on the value factor. We favour Japan equity, as the market still offers attractive valuations after the December correction, and light investor positioning, and it is a bit more sheltered from geopolitical tensions (trade disputes in particular).
Risks and hedging
We continue to suggest gold and yen exposure as hedges. Gold could also benefit from a more dovish Fed stance.
The table above represents cross asset assessment on a 3-6 month horizon, based on views expressed at the most recent global investment committee. The outlook, changes in outlook and opinions on the asset class assessment reflect the expected direction (+/-) and the strength of the conviction (+/++/+++). This assessment is subject to change.
NOK = Norwegian krona , GBP = British Pound, EUR = Euro, USD = US dollar, JPY = Japanese yen.
The U-turns in CB tones have pushed investors back towards the search for yield. It is time to focus on carry and fundamentals, after the strong spread compression.
The U-turn in central bank policies will likely prevent any material increase in long-term rates. Markets priced out previously expected Fed hikes and are now focusing on the changing stances of all main DM and EM central banks which are becoming more accommodative across the board. The new CB mood should support sentiment for risk assets (credit and EM), keeping the search for yield alive among investors, though the focus should now be on appealing carry opportunities, after the strong spread compression.
On US bonds, we have an overall neutral view on duration, given the Fed’s greater policy flexibility and the potential for an early end to the balance sheet taper. On a global perspective, we are more positive on the US, neutral on the UK, and less negative on the Eurozone, as we don’t expect to see further downside in yields from current levels. We confirm our negative bias on Japan. We also continue to be positive on inflation linked bonds, in particular in the US. In Euro fixed income markets, we are more constructive on peripheral countries with some opportunities in Italy and we continue to exploit curve opportunities (i.e. playing the 2-30 year differential in Germany).
Credit has been a big beneficiary of the rally and the valuation reset was very fast in January. Therefore, we have become more cautious in the short term, though we believe that credit remains a key yield engine for bond investors. In Euro credit, we keep our preference for subordinated debt financial. In US credit, after becoming more positive at the end of 2018 when credit spreads widened, we are now maintaining our stance. We focus on investment ideas in bonds that may not have fully participated in the rally, and at the same time we are taking profits in the areas that now appear to be fully valued. We remain wary of bonds from issuers with higher leverage than is appropriate for their credit rating. We continue to believe that structured credit sectors – specifically non-agency MBS, CMBS and ABS – may offer relative value to investors backed by a strong US consumer, and by the superior credit protections they offer relative to their quality ratings.
The start of the year saw an improvement in sentiment regarding EM debt. We expect that a more dovish tone by the Fed (and by other CB), a benign inflation outlook in most EM countries, and a stabilisation of economic conditions will continue to favour the asset class in 2019. On EM hard currency debt, we expect returns in line with the carry, while EM bonds in local currency may offer higher return potential, with many EM currencies still undervalued, albeit at higher volatility. We think investors should improve the quality of their portfolios, as risks persist (slowdown and trade).
On USD, we have a neutral view due to the more dovish Fed. We are turning more cautious on the Euro amid a weak economic momentum (prefer SEK & NOK) and neutral on the GBP given Brexit uncertainty. We are positive on JPY (safe heaven in case of turmoil) and we favour EM FX with room for further appreciation.
We still see positive earnings growth this year, but after the rebound, valuations are less attractive. Focus on sustainability of earnings is key in a late cycle.
The equity rebound has come on fast and we can reasonably now expect the markets to take a breath. Going forward, the focus will be on earnings growth. This has been revised down materially across the board, and the market is overall more vulnerable, being in a late cycle. However, in a central scenario of no recession, earnings growth should remain positive globally, with opportunities opening at regional/ sector and stock levels. Investors should be aware of potential vulnerabilities (slowdown, geopolitical risks), but at the same time exploit the opportunies that some price dislocation can open, as it happened in Q4.
In the US, there are really no meaningful warning signs or excesses in the market that usually precede a recession or bear market. In Q4 earnings season, companies have generally announced earnings that are stronger than low investor expectations, but the number of companies revising down expectations is the highest since 2016, and the deterioration in earnings revisions should be a focus. We still like the more cash-generative tech companies with solid competitive positions. We also like value and cyclicals with the lowest valuations. We are cautious on traditionally defensive sectors both in value (utilities) and growth (staples).
We remain constructive on EM equities although in the short term there could be a pause after the rebound.