The new ECB measure could support the corporate bond market, and there is more to come in case of a further deterioration of economic conditions.
Over the past 15 months, the Eurozone economy as a whole has slowed very sharply (+1.1% yoy in Q4 2018), while the US economy has accelerated (+3.1% yoy in Q4 2018), driven by tax cuts. However, we believe these trends could be reversed to some extent in the next 12 months.
In the United States, the first signs of a slowdown are emerging in Q1, while though the Eurozone is still weakened by external trade and political uncertainty (Brexit, trade tensions), it seems that the worst is behind us. True, the Eurozone composite Purchasing Managers' Index (PMI) fell by 0.6 pts to 51.3 in March (the small February rebound did not last), the manufacturing PMI fell to 47.6 (its lowest level since April 2013) and new export orders posted their lowest level since mid-2012 (with sharp declines in Germany and France). However, the situation in services is reassuring: the PMI for services has changed little (52.7 vs 52.8 in February). This tends to confirm our views that the manufacturing sector and world trade will continue to weigh on growth in Q1, but domestic demand remains resilient.
The FOMC just lowered its growth forecast to 2.1% for 2019 and 1.9% for 2020 (-0.2% and -0.1 % respectively vs December), in line with our expectations.
Fed Chair Powell said that the FOMC will wait before changing the monetary policy stance, particularly given the domestic and external risks to economic activity. In this context, the Fed is no longer forecasting any rate hikes in 2019 (vs two hikes expected previously) and this accommodative stance would continue in coming years.
The Strategist’s View - Central Banks abandoning normalisation
The ECB turned to an easier policy, surprising bond markets. The ECB surprised both on the timing of new measures and the likely persistence of the new easing stance:
TLTRO features look more in line with the consensus. It also looks adequate to provide, especially peripheral banks, with the needed flexibility in managing refunding “congestion” coming from maturing previous TLTROs and bonds over the next four years. Technical conditions have improved for corporate bonds, as lower supply pressure is likely to come from financials in the coming quarters, while the search for yield is likely to strengthen, mainly supporting BBB corporates, peripheral financials, and to some extent, high yield too. The shift to the year end of the forward guidance is going to work as a gravity force on govies’ yields in the short term. At the same time, the “lower for longer scenario” (lower rates for longer time) may force the ECB to reconsider normalising the negative depo rate as the next step, in order to reduce the unwanted side effect on bank profitability and to make the policy transmission more effective. In this case, a bear flattening of core govies’ curves would look likelier, but for the moment the ECB doesn’t look eager to move in that direction. The decision to index the TLTRO - 3 on the refinancing rate rather than on the deposit rate seems to leave open the door to such a normalisation by purpose.
DM= Developed Markets, EM = Emerging Markets, CB= Central Bank, ECB= European Central Bank, Fed= Federal Reserve. TLTRO= targeted longer-term refinancing operations.
We suggest a recalibration of risk to deal with market complacency: reduce DM equity and increase credit exposure.
Since the beginning of 2019, almost all asset classes are in positive territory, and volatility remains low. Are we living in a perfect world? Not really. Complacency is evident in certain areas of the market, where the rally has extended too far and too fast, going beyond what fundamentals justify. In March, we have become more cautious on risk assets in the short term, as risks seem more asymmetric. A significant amount of good news seems to be priced into markets. With most of the valuation gap closed, we would need some improvement in the macro scenario to see further upside from current levels. On the macro side, we continue to expect an economic slowdown and more downside risks, but very low risks of a recession. CBs will remain accommodative, but the risk that the Fed changes its communication policy too quickly is something that is worth monitoring. Any shift or signal of a less dovish Fed could provide a trigger for a market correction.
High conviction ideas
While remaining positive on a medium-term horizon on risk assets, we believe the market could consolidate at these levels, especially in equities. Consequently, as we expect a pullback and not a significant risk-off move, we suggest some tactical risk reduction and rotation. In particular, we have become more cautious on DM equities–valuations are not as appealing as they were at the beginning of the year, even if positioning is still light and many investors did not benefit from the bull run. Our reasons for becoming more cautious on European and US equities are the extent of the rally, and earnings revisions that remain depressed and show little evidence of bottoming out soon. In Europe, some political risk remains in the background (mainly Brexit, but also the risk of tariffs targeting the EU auto sector) which could weigh on EU equities.
In the US, the equity market is exposed to deteriorating economic momentum, and to noise arising from US fiscal policy, with the debate on the US debt ceiling expected to resume in the short term.
We remain positive on EM equity, and in particular Chinese markets, which look fairly valued and show improving fundamentals. In EM FX, we seek relative value opportunities, favouring those currencies with low external vulnerability and attractive valuations (eg, Ruble, Indonesian rupia).
On duration, we keep an overall cautious stance, with a preference for US Treasuries vs German Bunds (especially the five-year maturity), although at current levels, US Treasury valuations are not particularly attractive. In currencies, we have moved to neutral on the GBP amid the ongoing lack of clarity on Brexit.
Risks and hedging
Having reduced the overall risk stance, we think investors should trim the hedging (gold).
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.
The ECB’s accommodative stance may favour peripheral bonds and financial credit.
Positive conditions seem to be aligning for fixed income investors: slowdown in global growth, little or no inflation, and CBs committed to avoid further economic deceleration. Against this backdrop, we expect interest rates to remain low, capped by CB dovish positions and stable demand for assets perceived as safe havens. We expect that the search for yield will remain in strong focus. In March, more than $9.3tn debt* in global bonds had negative yields, up more than $3.5tn from the lows recorded in October, before the CB’s U-turn.
In US bonds, the fall of US treasury yields reflects the Fed’s more accommodative tone. The FOMC has paused its policy rate normalisation process (we don’t expect any interest hike this year) and is messaging patience and data dependence with respect to future policy rate moves. We expect the Fed will conclude the balance sheet normalisation by the end of the third quarter, which would be earlier than the market is expecting. Domestic inflation signals should be monitored as a key precursor to any shift in the FOMC’s current policy. At current levels, we take a more cautious view on US duration, within an overall stance close to neutral. Euro fixed income received strong support from the ECB’s new accommodative measures. This should benefit the peripheral bond market, favoured in the search for income. We maintain a slightly short duration view in Europe (moderately increased vs the previous month).
EU credit (peripheral financials in particular) is the main beneficiary of the new ECB TLTRO. We still see room for spread compression, as the search for yield will be particularly aggressive in Europe.
Although EM momentum has recently deteriorated, the continued dovish stance by the world’s major CBs might still play in favour of EM debt markets. A trade deal between US and China looks more likely; nonetheless, we keep a watchful eye on any negative surprise.
In the short term, we don’t expect the Euro to regain strength vs the USD, on a macro and ECB stance. We have a neutral view on GBP (due to Brexit), and on JPY, with a tilt towards appreciation if China-US tensions resume.
Data refer to Bloomberg Barclays Global Aggregate Negative-Yielding Debt Index. FOMC: Federal Open Market Committee.
We expect a range-bound market or possibly some consolidation. We prefer to play specific stories instead.
While the momentum of the global equity rally is quite strong, the outlook is uncertain, due to divergent forces at play: CB’s more dovish stance is generally supportive of equities, but, on the other side, the signs of global slowdown, along with persistent political risks and trade tensions are a challenge. The global profit cycle passed the peak, but we still expect single-digit growth in 2019. Revenues growth will be crucial. Earnings have already been significantly revised downwards and we expect some stabilisation, but a positive turn seems difficult. Valuations are less compelling, as many undervaluation gaps closed during this year’s rebound. On the other hand, the participation in the rally has been low, and this could further support the positive momentum. Given these conflicting dynamics, we prefer to play bottom-up opportunities and maintain a cautious top-down stance, expecting a range-bound market or possibly some consolidation.
The US market is at an inflection point; a continuation of the risk-on rally would require improving, or, at least, no further deteriorating fundamentals; an earnings recession could trigger a move to a risk-off stance. We take a cautious approach to the market, awaiting an increase in visibility. We see attractive opportunities in financials and industrials. European equities have posted a strong rebound, driven by the cyclical sector where we suggest taking some profits and looking for new opportunities, for example, in healthcare names with strong balance sheets. There is limited support from the ECB for the banking sector, as the ECB will keep the deposit rate unchanged until at least 2020. Fresh positive news on the political front and stronger earnings growth are now needed to support further market upside. The focus continues to be on stock picking, as valuation dispersion remains high. In Japan valuations are still attractive even if EPS momentum is slowing. We take a neutral stance, aware of the headwinds coming from a potential stronger Yen in case of a negative surprise on the tariff negotiation side.
Our view on EM equities is positive given the supportive backdrop of growth (differential vs DM expected to widen) and valuations (which still look attractive vs DM). Potential headwinds such as a strong US dollar and deteriorating US-China trade relations have eased somewhat and might support additional growth for EM equities. In Asia, we mainly favour China, as valuations stand at attractive levels and a trade deal looks more likely after recent positive developments. We also favour Russia on the back of cheap valuations and because sanctions on Russian banks have already been partially discounted. In Latam, we have a positive view on Brazil and Argentina, as the outlook in both countries is promising, but we keep watch for negative developments. We suggest a cautious stance on countries with high valuations and increasing political risk.