We expect the global policy mix to cushion the ‘uncertainty shock’
The summer months have been eventful. On the (geo)-political level, the sources of tension have multiplied globally. On the economic front, the growth momentum has weakened further, confirming the downward trend observed worldwide since April, with the deepening of the manufacturing recession.
Based on these conditions, we have revised down our global growth forecasts from 3.3% to 3.2% in 2019 and from 3.4% to 3.3% in 2020. In fact, part of the risk scenario has materialised, particularly with regard to trade tensions. Recent statements (from the US and China administrations) offer a ray of hope but the damage is done in terms of uncertainty – capex will stay under pressure, notably in countries most exposed to global trade. Consequently, we now expect an additional deceleration of growth, leading to subpar growth in advanced economies (AEs) in 2020, with a cycle trough either in H2 2019 or H1 2020. EMs are clearly not immune. But unlike Advanced Economies, EM growth should reaccelerate somewhat next year.
Risks remain clearly skewed to the downside, the risk of a recession has increased in the US. But we maintain our view that a global recession is not on the horizon.
In the US and in Europe, the job markets are supportive and the consumer is resilient. Moreover, we continue to observe a decoupling between the services and manufacturing sectors. But this is simply not enough in the short run to offset the pressure coming from trade and uncertainty. In Germany, even if we now foresee a technical recession (with slightly negative GDP growth in Q2-Q3 2019), it should be a mild and short-lived one.
In a low inflationary environment, the level of monetary accommodation is set to increase further. This is fully priced in by markets regarding interest rates.
On the one hand, the deterioration of the macro outlook justifies the global monetary accommodation that we are expecting but, on the other hand, we continue to think that markets expect too much from CBs (in particular from the Fed and the ECB, with regards to interest rates).
Looking ahead, the deterioration of the growth outlook paves the way for more fiscal easing (note that many EM countries have already moved in this direction). Fiscal policies should gradually turn more accommodative in AEs (starting with Germany).
At the end of the day, we expect the global policy mix to cushion the “uncertainty shock”. However in the current environment, we believe that fiscal policies are more likely to be reactive (i.e. become more expansionist if the outlook deteriorates further) than proactive (i.e. turn more accommodative pre-emptively).
From a more fundamental point of view, the fact that the average interest rate paid on debt has fallen below nominal GDP growth in several AEs, provides an additional argument to governments to act (as, in these conditions, a primary surplus is no longer needed to stabilise the debt/GDP ratio).
While we believe it is premature to price in the positive impact on growth, we expect that the anticipation of a global policy-mix turning more accommodative should help to anchor global growth expectations for 2020/2021.
In a highly uncertain environment, we think investors should have a cautious risk exposure and search for yield in Euro credit IG and EM bond with an increased focus on liquidity management.
Given concerns of sluggish global growth and heightened volatility in light of the US-China trade dispute, we remain cautious with respect to our views on risk assets. Our move last month to go long on duration and stay defensive on equities was well rewarded by the markets. Markets are already pricing-in a 100 bps of rate cuts by the Fed and 30 bps from the ECB in the next 12 months. We believe it is time for investors to have a mild risk exposure with preference for European IG credit, but be mindful of the opportunities that this volatile environment might present.
High conviction ideas
Developed market central banks, including the ECB and the Fed, seem to indicate their willingness to support economic growth by adopting a more dovish stance. In the short term, this is good news for DM equities, but we remain selective. In addition, on the back of an accommodative macroeconomic environment, we are starting to reconsider out negative view on the Schatz, given that a high possibility of rate cuts doesn’t support it. On duration, we remain positive on the US as a diversifier of the risk exposure, owing to slowing global growth and inflation, and the recent escalation of the trade war. As a result, we maintain our preference for the 10y UST and for the UST 5y vs German 5y. In credit markets, we expect the hunt for yield to intensify in Europe on the back of a fall into negative yields for most Euro government debt. We continue to favour Italian BTPs and EUR IG vs HY (more Equity like) that should benefit from technical factors such as inflows, TLTRO, and likely ECB QE2 and rate cut. We stay cautious on US Credit as it is too leveraged with respect to its fundamentals. In EM equity, we keep a neutral view due to unattractive aggregate valuations, deteriorating macro-economic momentum and negative earnings revisions.
We maintain our preference for Korea as it is giving signals of bottoming-out and also for China. On the EMB side, we remain positive on hard currency, mostly for carry reasons, but are cautious on local currency debt which is subjected to high volatility due to the FX exposure. In general, financial environment seems supportive for EM Debt (attractive carry, low US rates, dovish Fed and dovish EM Central Banks, and subdued inflation), but concerns on global trade and growth are headwinds, especially for local currency debt. In currencies, we maintain a relative value approach, with a preference for a FX basket of higher carry EM currencies vs South African Rand and the South Korean Won, which should depreciate more on re-escalating US-China trade tensions.
Risks and hedging
Geopolitical tensions and global growth worries continue to dominate financial markets. Subdued economic data from Germany and China raised concerns over a recession. Uncertainty in Europe increased with Brexit and Italy as key hot spots. As a result, it is important to note that fundamentals remain at risk at company level, given that profit margins could decline in case of weakening global growth and trade war escalation. Liquidity risk may also resurface should central banks disappoint the market expectations.
In this environment, investors may mitigate risk by adopting an adequate hedging strategy in form of gold. This would safeguard investors in case of an escalation in the currency war between the US and China. Investors may also consider to retain a positive view on US duration as a liquid hedge, but look to marginally reduce it after an impressive rates rally.
The table 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.
USD = US Dollar, JPY = Japanese Yen, Schatz = 2Y German Treasury Bond
In case of disappointment of markets expectations on policy actions volatility will be back. Time to be cautious on credit selection and manage liquidity risk.
Two issues compound the situation for fixed income markets, the US-China trade war and concerns over global economic growth, and expectations of aggressive rate cuts by central banks (CBs). After the rate cut by the Fed in July, the market is now pricing-in additional cuts in 2019 and some additional ones in 2020 (100 bps overall). In Europe, an accommodative stance should remain for a prolonged period. However, there is a possibility that markets are expecting too much and we may see more volatility in case of disappointments. We are also increasingly selective in credit, where liquidity risk assessment is at the forefront.
From a global fixed income perspective, we have an overall neutral duration stance and believe some tactical adjustment in EUR & US duration could benefit investors, given the recent dovish ECB statement. We maintain our positive view on US duration, while reducing the short duration stance in Europe. With respect to EU sovereigns, we keep a constructive view on the main peripheral countries but are now more cautious on Italy BTPs as the 10y spread vs Bund has tightened significantly. We also continue to seek opportunities from yield curve movements both in Europe and in the US. From a US investor perspective, we have become more cautious on duration amid the strong rally.
In the US, given narrower credit spreads and lingering macro uncertainties tied to global trade policy, business sentiment and the Federal Reserve’s policy reaction function, we are moderately constructive.
Compared to IG credit (where we are cautious on the BBB space) we prefer securitized credit sectors such as asset-backed securities (ABS), commercial mortgage-backed securities (MBS) and residential mortgage-backed securities that can benefit from a still strong consumer sector. We also see selective opportunities in US high yield on the BB and B space that provide better liquidity profiles. In European credit, we are still constructive but selective, preferring short-term maturities with high spreads. Overall, we have become more cautious on financials, especially Italian and UK banks.
We are navigating a complicated market environment amid a global growth slowdown, anchored inflation expectations and elevated trade tensions. In this environment, central bank easing – in an effort to mitigate trade war risks and stimulate growth and inflation – could be supportive of EM fixed income. We believe EM bonds still offer potentially interesting return prospects and remain attractive for investors hunting for yield. But we have become more defensive with a more positive duration stance. We have a preference for Brazil, Indonesia, Serbia, and Ukraine and continue to favour selectively the hard currency space.
We remain positive on the USD and JPY as a hedge. We have become more negative towards the GBP due to a fluid political situation and the increased risk of a no-deal Brexit. We are also cautious on the commodity-bloc and on EM Asian currencies threatened by the escalation in the trade war.
GBP= British Pound.
Low yields make equity risk premia more attractive, but given the uncertainty on earnings growth it is key to focus on quality and valuations.
Equities reacted to the summer volatility as we witnessed a reversal of globalization in the form of increased protectionism and trade-wars. As a result prices now more closely reflect weaker fundamentals. Low bond yields make equity relatively attractive. However, the outlook is more uncertain, as earnings expectations are still high for 2020 and we could expect further downward revision. From an economic standpoint, there are expectations of stabilization at low levels of growth.
In Europe, the reporting season has been largely in line with expectations but forward Q3 and Q4 estimates have declined. We believe 2020 earnings estimates are too optimistic and would be revised downwards. Portfolio balance remains important for investors, given the uncertain macro-economic environment. We continue to find opportunities among cyclicals such as industrials and energy. In particular, we prefer companies with high quality business models and strong balance sheets. While the value sectors are historically cheap, we are mindful of highly indebted companies and those that are particularly exposed to disruption in areas such as retail, media, and autos unless we are adequately compensated for the additional risks. Defensive sectors such as consumer staples have high valuations now. We also see limited opportunities in IT, materials and utilities. Encouragingly, health care and telecommunication present opportunities.
In EU, the banking sector appears structurally challenged, given falling rates. While there are no clear triggers, we believe the valuation of this sector is cheap and a significant tactical opportunity to buy European banks should arise. In an overall neutral view on financials, we prefer banks over insurers. In the UK, no deal Brexit risk has increased. This would have implications on the domestic economy and broader European countries.
In the US, among US cyclicals, we expected a volatile earnings season for Q2 and that is essentially what happened, albeit it was not as bad as originally feared. Therefore, we are now cautious towards the more cyclical sectors, as this is where we have seen the most pain points from quarterly results and management outlooks. From a style perspective, although we still prefer growth, we now believe valuations are extremely stretched in med-tech, software and consumer space. Bond proxies and other low volume stocks still appear very expensive, with the exception of real estate which is the preferred bond proxy. Overall in the US, we prefer sectors such as consumer discretionary, health care, financials. We are negative towards industrials, utilities and consumer staples.
EM equity reacted negatively to the deterioration in US-China trade relations and the primary vote outcome in Argentina (and the following downgrade by rating agencies). Geopolitical risks and uncertainty remain elevated, leading to an increase in investor risk aversion and market volatility, and we expect this to be only partly offset by central banks’ easing stance. In this environment, despite attractive valuations, we prefer to be overall more cautious in the short term. Relatively, we favour countries less exposed to external vulnerabilities and with good valuations (such as Brazil, Russia, India).