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Asset Allocation Letter - Where do we stand on the global Reflation trade?

EDITORIAL

 

Most comments published on this front are focused on President Trump’s election. Since then, investors have been building up expectations of a sizeable fiscal stimulus through corporate tax cuts and financial deregulation to significantly prop up growth in the largest world economy. These, to us, have definitely been part of the catalysts, but can rather be seen as magnifiers of an already-established trend.

Since last September, global macroeconomic data have been broadly accelerating, as illustrated by business surveys hitting record-high levels. Deflation fears have been progressively fading away, helped by the significant rebound of commodity prices. One should note that this drift has not been restricted to the US, but we have observed a pick-up in activity in Eurozone and Japan as well, while Chinese growth has significantly surprised the consensus on the upside.

Markets had initially reacted very strongly – the so-called ‘Reflation trade’ – with risky assets in developed markets, and more particularly, US cyclicals including banks outperforming defensive and emerging peers, and US inflation breakevens repricing significantly higher. After rushing into it in a hurry, investors have apparently started during the first weeks of 2017 to search for evidence before confirming their initial enthusiasm. In the meantime, barring any announcement of a game-changing fiscal incentive or a strong protectionist turn from the US towards its major Far East partners, the reflation trade somehow took a breath.

At this stage, with the Fed hinting that all conditions are met for a hike in March and with a continuation of the strong positive macro momentum, we stick to playing the reflationary environment while rotating to some less crowded and expensive assets, especially tapping into the Eurozone.

 

 

Florian Neto, CFA

Multi-Asset Client Portfolio Manager

CONVICTIONS

Investment scenarios

  • Our central scenario, based on a limited but stabilized global growth remains valid - around 3.3% per year in 2016-2017 – with a 70% probability of occurrence (stable). US growth should be slightly higher than expected for 2018 (2.2% vs 1.7%) and Developed Economies globally driven by domestic demand (Europe, US, Japan). Emerging Markets should improve benefiting from the stabilization of oil prices. This environment should favor risky assets and also QE friendly assets (Euro Corporate and Equities, Peripheral Sovereign Debt).
  • Our first alternative scenario (increased at 20% probability) assumes an acceleration of US growth as well as US inflation expectations thanks to fiscal expansion leading markets to reprice rates higher and USD stronger, with the Fed eventually more aggressive than initially anticipated. It would create a widening gap between disappointing growth expectations and sustained inflation expectations.
  • Our second alternative scenario sees a global growth slowdown with 10% probability of occurrence (decrease). The trigger could be a deterioration of the US economy (Trump downside), tighter policies in China or the consequences of the Brexit vote.

 

Positioning under our central scenario

The intermediate risk budget is stable at 5/10.

  • On equity markets, we are overweighed in directional.

- Geographically, we maintain our long exposure to Eurozone, a region that could benefit from a potential catch up and earnings revision and also to Japan notably supported by the macro momentum and valuations. We still have a neutral exposure to US. On Emerging Markets, we remain cautious as there are still question marks related to USD level, US interest rates hike and risk on US tariff policy. We keep the underweight on Europe ex-EMU.

- Sectors/factors: we still favor the Value bias in Eurozone and the Quality in the US, taking partially our profits on the US Value exposure.

  • In the fixed income space, we keep an underweight exposure in nominal duration (Euro Core) and a long exposure to higher yielding FI assets (Credit, EM)

- Rates: We maintain a short duration exposure to Core Eurozone and a moderate long exposure to Peripherals. We maintain a long exposure to US duration via a position on US 2Y. We also keep a long exposure to Euro and US Breakeven.

- Credit: We are globally positive on the asset class. We balance our overweight exposure between Industrials and Financials and maintain a long position on US Investment Grade. We also have long positions on Euro and US High Yield.

  • Currencies: we maintain a long position on JPY to benefit from its risk-off feature and slightly increase the risk budget on Emerging Markets Forex (MXN).
  • Macro Hedging: we still prefer equity volatility to other macro hedges and wait for the good entry point to reinforce the exposure to US treasuries. We’ve partially reduced the exposure to Gold Miners as the asset class has already offered a good performance.

 

Cross asset views and portfolio positioning

RISK LEVEL: 5 / 10

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FOCUS

Economic and business cycles at the core of the equity process

Our investment philosophy has always been top-down and fundamentally driven. Indeed, we have the strong conviction that assets pricing is driven by 1) investors’ perception about the state of the global economy and by 2) absolute and relative valuations.

This philosophy is also key for our equity investment process. Indeed, we believe that understanding both macroeconomic and market dynamics, as well as the implicit assumptions behind current market prices are key success factors for performing well. As a consequence our investment approach is based on the fact that economic and business cycles are key drivers of value changes in the markets, sectors and stocks while profits, valuation and factors approach offer the flexibility to add substantial value throughout the different stages of economic cycles.

 

1. Profits cycle to assess our directional exposure

Since the early 1800s, earnings and prices performance have exhibited a close relationship. Consequently, assessing to which extent investors’ earnings expectations are over- or understated is critical to identify equity markets opportunities. In this context, we have built a top-down model which precisely forecasts the next twelve months’ profits growth for most of the developed markets (US, Euro zone, UK, Japan) and for the overall emerging region. The difference between our multi-regression model and a traditional OLS model (Ordinary Least Square) is that we use a dynamic factor model with time-varying coefficients. This measurement tool is designed to capture changing co-movements among time series by allowing their dependence on common factors to evolve over time. Our explanatory variables change according to the region to which we apply our model. Our time series are rather long, in some cases enabling us to provide forecasts since the early 70s. Our results show a good fit with the overall profit cycle and predict changes in profits forecasts ahead of market consensus.

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In the US, our forecasts for profits growth are explained by macro variables such as GDP, US trade weighted index, US Chicago Purchasing Manager Business Index, oil prices etc. The macro variables have been selected checking for 1) their contribution to minimizing the overall error regression model and 2) their contribution to predicting the dependent variable, in that case US profit growth for the coming four quarters. Once we have analyzed the profits cycle of the major developed and emerging regions and compared our results to what investors expect (IBES consensus) we know where potential upside/downside surprises may come from. We therefore invest in those countries where earnings growth is not priced in by valuation metrics and conversely we sell those countries characterized by high valuation and low profits growth expectations.

 

2. Global valuation helps to see if growth is already priced in or not

We integrate a number of valuation indicators in our process, including all well-known and traditional metrics (P/E, P/BV, P/Sales…). Absolute and relative valuations are computed and reviewed constantly to take new information and price movements into account.

Beyond these traditional indicators, we also look at the Shiller PE, or cyclically-adjusted PE (CAPE), which provides a longer-term valuation yardstick, and from which we draw a long-term expected return assumption that would be compatible with different levels of CAPE. We also calculate the Equity Risk Premium for most of the developed and emerging regions. This model gives a clear signal about the expensiveness of the equity market relative to government bonds or to corporate bonds.

The cyclically-adjusted price-earnings is very helpful to set long-term expected returns. Indeed, according to the current valuation levels, the US stock market should deliver a very low single-digit annualized return.

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3. Factors investing help in alpha generation

If valuation and profits forecasts help set up directional exposures, factors investing is key for alpha generation in benchmark and absolute return funds. From time to time, when we see a shift in the cycle, we may change our style from pure value investing to a blend of quality and value investing, or a bias towards more quality investing if we believe the cycle is turning for the worse.

Investment managers quantitatively screen value-driven and quality opportunities across multiple countries. We believe that long-term outperformance can be achieved by investing in companies which are leveraged to the business cycle when economic growth accelerates (value stocks) or companies which are resilient to the economic cycle when the risk of recession increases. Our Value selection is based on undervalued companies and solid balance sheet. We avoid P/E and P/BV screeners as traditionally low price-book value ratios may detect companies which have business troubles and P/E as levels depend on the economic cycle. We therefore prefer the Ebitda yield (Ebitda divided by enterprise value) as the multiple is less impacted by financial leverage and focus on cash flow measure rather than earnings. In order to avoid low valued companies with business problems, we cross our value screeners with the Piotroski’s score.

 

 

 

 

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Our Quality selection is based on companies showing historical steady operational performance and lower earnings volatility through economic cycles. In order to avoid expensive companies which may lose their defensive profile during periods of high volatility, we avoid expensive stocks within the universe. Our bottom-up approach typically includes multiple valuation techniques including absolute and relative valuation.

 

As a conclusion, our stance on various equity markets is a combination of:

  • the impact of our central and alternative scenarios on stock markets
  • the monitoring of earnings trend
  • the integration of different valuation indicators
  • market dynamics, which help us in the timing of potential changes in our investment strategies
  • factors allocation across countries

 

Claudia Panseri

Multi-Asset Portfolio Manager

 

PERFORMANCES

Gross performances of our strategies (February 28, 2017)

Amundi, data as at end of February 2017. Gross performance of “Balanced Institutional Absolute Return Low volatility “, Multimanager Multi-Asset Fund of Funds (Bonds)“ GIPS composites in euro. Their respective benchmarks are: Eonia capitalized and a composite benchmark: 50% JPM EMU Government Bond Index, 30% JPM Government Bond, 20% Exane ECI – Europe Convertible. Past performance is not a reliable indicator of future results or a guarantee of future returns.

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Laurent TIGNARD, Global Head of Multi-Asset, Institutional Clients
Frédéric PASCAL, Deputy Head of Multi-Asset, Institutional Clients
Eric TAZE-BERNARD, Chief Allocation Advisor
Marc-Ali BEN ABDALLAH, Strategy and Economic Research at Amundi
Florian NETO, Client Portfolio Manager
Dan LEVY, Head of Multi-Asset Investment Specialists
Bénédicte GUILLEMOT, Investment Specialist
Leslie DEBOUT, Investment Specialist

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Asset Allocation Letter - Where do we stand on the global Reflation trade?
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