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28.07.2021  

Global Investment Views - August 2021

Published July 28, 2021

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From growth euphoria to inflation blues


The past weeks have confirmed that phase one of the ‘great recovery’ is now behind us. We have entered a new sequence: PMIs decelerating from their peaks and concerns about the spread of the Delta Covid19 variant are features of it. Some cracks in the reflation trade that has lifted markets in 2021 have driven a pause in the cyclical/value outperformance. In contrast, the acceleration in inflation continues, with the latest numbers in the US once again far above expectations. Where things will land in terms of economic growth and inflation are the big questions now. On growth, future expectations have been revised downwards but on inflation markets believe the inflation pick-up is temporary. This means that while a few weeks ago the consensus was for ‘great’ higher growth with still-low inflation, in recent days we have moved to somewhat lower ‘good’ normal growth with still-low inflation. The next move may be more challenging, as the probability is rising that we are entering a scenario of uncharted territory, with lower growth and lasting inflation above central bank-target (strong housing market, mismatch in labour market). The inflation-versus-job-markets equilibrium is increasingly an issue for the Fed as economic growth decelerates and inflation risks look like they may last longer than expected. The window of opportunity for the Fed to start tapering is narrow and communication matters more than ever now. On the investment front, we stick to some key convictions to navigate this uncertain time: 

  • It is not a time to add risk, we maintain a neutral risk stance. We are approaching an inflection point on Fed policy and conditions could quickly turn more volatile as markets are still too complacent on inflation/yields. Any short-term correction in equities could offer better entry points. In fact, equities tend to perform better than bonds in an inflationary environment (but not hyperinflation). However, investors should remain vigilant on economic data and the Q2 earnings season to assess whether or not companies will be able to pass rising costs on to consumers and keep margins safe.
  • Regarding equities, we confirm the value rotation call but are aware the road will remain bumpy. Markets face two concerns regarding valuations: (1) how rates will increase and how this will affect valuations; and (2) if growth stalls, how this will affect earnings and margins. We think the latter is driving markets more. But when there is clarity on growth and the potential spread of virus variants, the focus should return to rising rates and favour value once again.
  • In bonds, a short duration stance is recommended, together with greater scrutiny on credit. When the Fed decides to announce tapering, investors could be forced to judge how that affects their credit exposure. Credit that is extremely sensitive to core yield movements should be avoided. Instead, the focus should be on businesses with the potential to improve fundamentals and credit metrics (sales growth vs. debt growth). CBs remain the key players in this inflation/growth trade-off. The ECB continues to appear dovish, as it switched from its lower-than-2% inflation target to a more symmetrical 2% inflation goal, where upside and lower deviations are equally undesirable. This review removes an inherent deflationary bias present in the previous system, which made above-target movements in inflation unacceptable. It also puts at the forefront the ECB’s green agenda in its asset buying. In China, the reality of slowing growth has resulted in the PBoC realising that economic momentum is slowing, leading it to end tightening by reducing the amount banks are required to hold as reserves. Given that Chinese demand now drives global demand and inflation, movements in the Chinese economy and money supply have the potential to affect DM. These differences in CB policies provide the opportunity to play relative value trades in bonds and FX. We see value in Chinese bonds and the CNY amid the prospect of their inclusion in global bond benchmarks (FTSE global index).
  • In EM, some headwinds should be taken into consideration. While we do not expect to see a 2013-like taper tantrum, we are preparing for gradual hikes in US rates with a cautious duration stance and with selection in credit. In EM, the cyclical recovery is likely to be delayed, as infections due to the Delta Covid-19 variant have been on the rise because vaccination rates in EM lag those in DM. Against this backdrop, we maintain a prudent approach, in particular on LC markets.

To conclude, we think we have entered a new phase: the euphoria regarding growth has gone and the focus is now on inflation blues. Markets should not be worried about the Fed’s action at this point: for example, with regard to a scaling back of purchases in the mortgage markets. A little dose of tapering could help avoid nasty consequences and bubbles later on.

CROSS ASSET RESEARCH ANALYSIS


Unconventional monetary policy and UST rates

The long end of the UST yield curve has endured years of unconventional monetary policy (UMP). At the beginning of Q2, we were prepared for higher volatility in bond markets, calling the end of the “great moderation” endorsed by policymakers. The speed and the direction of long-term Treasury yields caught us by surprise. In particular, the persistent descent of the UST10Y in the face of rising inflation and improving economic and corporate earnings growth challenges our short duration view. A variety of explanations lie behind this move: market participants fully buying the ‘transient’ inflation story, CTAs’ automatic repositioning (systemic strategies), ‘irrational exuberance’ in the financial markets and, more recently, the flight to safe havens amid fears of the spread of the Delta Covid-19 variant.
Where do we stand in all this? We think the Delta variant is a prominent risk but that recession fears are overdone at this stage. While vaccines alone may not be the endgame, governments have learnt how to temper the spillover of the pandemic on economic growth. Incidentally, US growth peaked in Q2 and will progressively decelerate to potential in 2023. We also believe that current inflation levels are transient but an inflationary regime shift is in place (estimated US CPI for 2021 is 4.1%), with some key elements such as shelter, PPI and the green transition being more persistent. This leads us to the view that a first leg up of higher rates this year will rely on a genuine growth improvement and a further one will rely on drifting higher price dynamics. This is not materialising yet. While we are convinced that positioning played a role in yield movements, long-term real yields have endured years of UMP and therefore fundamentals must be considered. Based on our simulations1 applied to the US yield curve, we can draw certain conclusions: (1) central banks’ UMP has induced a paradigm shift to key drivers of rates, i.e., long-term inflation expectations (the 5Y5Y inflation swap), the Fed balance sheet (B/S) to total US debt ratio, and investors’ sensitivity to this ratio. Importantly, rate hikes will have a limited impact on the long end (i.e., a 25bps hike would likely lift the UST10Y yield by 6bps). Long-term expectations remain anchored (5Y5Y at 2.46%) and asset purchases remain the major driver of long-end real rates. In addition, the combination of balance sheet changes to US total debt and investors’ sensitivity to this ratio explains almost -100bps on the UST10Y real rates and -180bps on the UST30Y. The Fed balance sheet/total US debt ratio is now at a record high of 28.06% and is expected to move to 28.6% in a year. Surprisingly (and unrealistically), if it is reduced to 26.9% (i.e., tapering the $120bn in 2021 to $0 asset purchases in 2022), everything else being equal, the UST10Y will shift to 1.8%. For even higher rates, we would need higher long-term inflation expectations and/or the Fed to lose credibility;
(2) fundamentals at present set the UST10Y fair value at 1.7%. Market participants’ addiction to UMP sets a cap to the upside potential of yields; 
(3) for the UST10Y to rise above 2%, long-term inflation expectations must move persistently above 2.75-3%, and a remarkable shrinkage of the Fed’s B/S or an increase in US debt would be needed;
(4) in an alternative scenario, for the UST10Y to move above 2%, rates must turn inelastic to B/S changes, everything else remaining equal. This might happen if the Fed loses credibility (bad) or successfully normalises to pre-Lehman levels. Only this case is positive for risk assets.
To conclude, we believe it will be difficult to ‘deaddict’ the markets from years of UMP and hence changing the sensitivity to the Fed’s B/S will take some time. We reiterate our view of the UST10Y yield moving to 2-2.30% in the next 12 months.

Unconventional monetary policies largely explain the subdued levels of yield on the 10Y US treasury, despite higher inflation: we confirm our target of 2-2.3% for the next 12 months.

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MULTI-ASSET


Explore all ‘levers’ and wait for better entry points

The economic backdrop continues to be favourable for risk assets, but importantly we are now approaching the peak of the growth resulting from the post-Covid-19 reopening. On the other hand, inflation is increasingly becoming a risk to consider, and this is not yet priced into markets. However, now is not the time for a structural de-risking but rather a time to monitor hard/soft data and the Fed’s communication. Investors should also look for indications of sustainable earnings growth, which could provide attractive entry levels in equities. Thus, with a vigilant stance, investors should use a diversified array of assets, including Chinese debt, to ensure robust riskadjusted returns in a low-rate environment in DM. Investors should also implement relative value strategies and enhance hedges amid the Covid19-related risks on the horizon.

High conviction ideas
We are neutral on equities, maintaining a ‘waitand-watch’ view in both DM and EM.
We believe the focus on valuations is even more important now because the return of inflation and potential stagflation worries are raising some questions on corporate margins. While there are some headwinds (i.e., the recent curve flattening) to the cyclical/value rotation, the reopening of economies, the spread of virus variants and earnings growth are the key variables to watch. On EM, we are neutral overall but with a positive stance on offshore Chinese equities, given the country’s stable economic growth, its reorientation towards domestic consumption and continued government policy support (policy divergences from the US) should benefit equities in the long term.
Our defensive stance on the 10Y UST and on core Euro debt is maintained. The former should be weighed down by a recovering US economy, rich valuations, rising deficit and inflation. But this upward yield movement will not be linear, so it is important to remain flexible. In addition, we keep our UK 2-10Y curve steepening view in light of the economic reopening and inflation expectations, but we are closely monitoring rising infections.
Going forward, the importance of Chinese assets will increase for global portfolios. Hence, we are now constructive on local government debt as it should benefit from positive sentiment and continued flows (passive investors) for the next few years based on its inclusion in global indices. In Europe, we are constructive on our relative 30Y BTP vs. Bund position. Peripheral debt is supported by the reaffirmed ultra-easy stance of the ECB and a lower BTP supply for the remainder of the year.
Credit remains a key source of return and we like EUR IG and HY due to their attractive carry, deleveraging and improving credit metrics. Despite tight valuations, IG continues to be supported by the global reopening, the favourable risk sentiment and technicals, driven by ECB purchases. In HY, favourable economic prospects and financial conditions for the EZ, downward trends in default rates and attractive carry allow us to stay positive. On EMBI spreads we remain neutral.
Further, when tight valuations and positive economic backdrops persist simultaneously, we believe a relative value approach towards FX can unearth strong investment ideas. We are now optimistic on BRL/EUR because of rapid vaccinations, the improving economy and normalising rates (attractive carry). We also look at FX through a geopolitical lens. We maintain our positive stance on KRW (semiconductor cycle and green transition) and CNY (driver of intra-Asian trade) vs. the EUR. In DM we are cautious on GBP/EUR but maintain our reflationary view through the FX carry trade basket of the NOK, CAD, GBP, USD vs. the EUR, CHF and JPY.

Risks and hedging
While the economic environment is positive for risk assets, we see some risks related to the spread of the Delta Covid-19 variant, with some possibility of renewed lockdowns after the summer. Hence, we recommend the use of hedging strategies to safeguard DM equity exposure.

In an environment of stabilising growth momentum and an upswing in inflation, a diversified allocation allows investors to extract value from a broad array of assets and protect their exposure in case of a downturn.

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FIXED INCOME


Don’t chase the falling yield trend at these levels

While the inflation and growth debate continues, bond markets seem to have gone too far in pricing in a pessimistic scenario of very low growth due to the spread of the Delta variant. We believe the low hospitalisation levels indicate only a limited possibility of a repeat of the complete lockdowns we saw last year. However, uncertainties remain in the form of the size of the US fiscal package and slowing vaccinations. Thus, while staying agile, and tactically playing opportunities (on duration, and yield curves), investors should maintain long-term convictions, not chasing the downside trend in US bond yields, and monitor the movement of real rates and the Fed’s communication. We remain mildly positive and active on risk assets as the economic recovery continues.

Global and European fixed income
With an overall active stance, we remain cautious on UST and core Euro bonds but recommend investors balance these with some tactical positions at curve and country level. Overall, we see some curve steepening potential in Europe but think investors should reduce their flattening stance on Italy. We remain constructive on euro peripheral bonds and Chinese bonds. Unsurprisingly, we are optimistic on inflation in the US and Europe.
In credit, the environment is benign as metrics are improving but it not a story of sectors but rather of idiosyncratic risks. We are constructive on credit and advise investors to keep shorter duration debt amid the risks to portfolios from rising rates, inflation and liquidity concerns. Interestingly, investors can avoid asymmetric risks by focusing on selection and fundamental ESG analysis (increasing importance in light of the ECB review, COP26). Furthermore, we like the themes of subordination, ratings (rising stars in BB-rated debt) and sectors (cyclical recovery).

US fixed income
Biden’s stimulus plans are hitting speed bumps but the Fed continues to prioritise employment generation over inflation. We think rising debt and the fiscal deficit are likely to pressurise the USD and Treasuries. Hence, we are cautious on duration but stay active and are monitoring the growth concerns stemming from the slowing vaccinations. Our convictions on growth and inflation allow us to believe in yield curve steepening. The search for income persists in corporate credit as real rates are negative. Our focus is on resilient names amid rates and inflation pressures. We prefer idiosyncratic risk over beta exposure (IG). HY, on the other hand, is more attractive from a carry perspective, but selection is important. Residential and consumer mortgage markets remain strong amid high consumer earnings and low delinquencies. However, expectations of duration extension could be a risk.

EM bonds
Resurfacing inflation in certain countries and concerns about peaking global growth are the key factors to watch. We favour HC credit risk but are cautious on duration. LC bonds are still expensive and require a selective approach. Not surprisingly, lower-rated names in HY have been weak but higher-rated ones have shown resilience. Thus, we remain focused on selection to balance yield, quality and liquidity.

FX
The situation is nuanced on the USD amid twin US deficits and the rising growth differential with the world. We have reinforced our dollar view and look for signs at the Jackson Hole meeting. We are now positive on the CNY but less constructive on commodity FX (AUD, MXN, RUB). However, we keep our cautious view on EUR, JPY and CHF.

Investors should prioritise selection over market exposure in order to limit their duration exposure and asymmetric risks, and also to generate robust inflation-adjusted returns.

2021.08-GIV-figure-3

GFI = global fixed income, GEMs/EM FX = global emerging markets foreign exchange, HY = high yield, IG = investment grade, EUR = euro, UST = US Treasuries, RMBS = residential mortgage-backed securities, ABS = asset-backed securities, HC = hard currency, LC = local currency, CRE = commercial real estate, CEE = Central and Eastern Europe, JBGs = Japanese government bonds, EZ = Eurozone, BoP = balance of payments.

Equity


Better entry points to play the value rotation

Overall assessment
Reflationary momentum has been affected by growth concerns and the spread of virus variants. However, hospitalisations remain low and that serves as a confidence booster for the value/ cyclical trade even if we continue to believe earnings growth will drive markets. The recent correction of value is not, in our view, the end of the trade but provides better entry points for it. The important questions for companies now are how transitory price pressures are and what their ability to pass price rises on to consumers is. Companies with intellectual property and strong brands are better positioned in this respect. Overall, the relative valuation of equities vs. bonds is attractive but assessing the inherent strength of businesses is the path going forward.

European equities
We continue to believe in a recovery supported by vaccinations but are monitoring hospitalisations, which may affect the reopening in certain countries. We also believe in rotations towards quality value and cyclical stocks, although we are aware that it will not be linear. We are positive on industrials and financials. On the other hand, we acknowledge the risks to some peaking of growth momentum and keep a balanced stance. We like defensive sectors, such as telecoms and healthcare (less positive). Some segments of the market, notably information technology (IT), are extremely ebullient, leading us to raise our cautious stance. Overall, we continue to explore opportunities through fundamental ESG analysis. We are defensive on the energy sector due to issues around sustainability but valuations are very attractive, so we may find selective opportunities. We also favour the dividend theme.

US equities
The value vs. growth performance has weakened recently due to concerns related to reopenings, virus variants and falling yields. We believe this recovery should continue amid the low hospitalisations and that the accompanying demand (demographics) will be supportive of a recovery in the medium term. As a result, the growth outperformance of the past month is unlikely to be sustained. While we like highquality cyclical value names, we focus more on businesses’ strengths and strategies. We are exploring value tech in light of the higher margins and domestic value, as well as cyclical names as these companies tend to have better control over supply chains relative to the more global names. Pricing power and bottom-up selection are crucial. Our sectoral preferences in financials and energy reflect our continued tilt towards normalisation and reflation. We also like select defensive names in the healthcare sector that provide some balance to our normalisation bias. We avoid expensive growth names in the technology sector and distressed value.

EM equities
EM prospects are supported by attractive relative valuations and strong earnings potential. We believe the upward trend in the earnings recovery in 2H21 will be concentrated in EMEA (Russia) and LatAm (Brazil). At a sector level, we favour discretionary, real estate and industrials, but maintain a cautious stance on healthcare and have downgraded Chinese financials. However, the moderation of Chinese growth, the global bond yield environment, the spread of the Delta variant and idiosyncratic tensions are all risks.

While relative valuation of equities is still attractive, investors should rely on a disciplined selection process to identify companies that can protect margins in the face of rising input costs.

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Amundi asset class views


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Definitions & Abbreviations


  • Agency mortgage-backed security: Agency MBS are created by one of three agencies: Government National Mortgage Association, Federal National Mortgage and Federal Home Loan Mortgage Corp. Securities issued by any of these three agencies are referred to as agency MBS.
  • Beta: Beta is a risk measure related to market volatility, with 1 being equal to market volatility and less than 1 being less volatile than the market.
  • Breakeven inflation: The difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked investment of similar maturity and credit quality.
  • Carry: It is a return of holding a bond to maturity by earning yield versus holding cash.
  • Correlation: The degree of association between two or more variables; in finance, it is the degree to which assets or asset class prices have moved in relation to each other. Correlation is expressed by a correlation coefficient that ranges from -1 (always move in opposite direction) through 0 (absolutely independent) to 1 (always move in the same direction).
  • Credit spread: The differential between the yield on a credit bond and the Treasury yield. The option-adjusted spread is a measure of the spread adjusted to take into consideration possible embedded options.
  • Currency abbreviations: USD – US dollar, BRL – Brazilian real, JPY – Japanese yen, GBP – British pound sterling, EUR – Euro, CAD – Canadian dollar, SEK – Swedish krona, NOK – Norwegian krone, CHF – Swiss Franc, NZD – New Zealand dollar, AUD – Australian dollar, CNY – Chinese Renminbi, CLP – Chilean Peso, MXP – Mexican Peso, IDR – Indonesian Rupiah, RUB – Russian Ruble, ZAR – South African Rand, KRW – South Korean Won.
  • Cyclical vs. defensive sectors: Cyclical companies are companies whose profit and stock prices are highly correlated with economic fluctuations. Defensive stocks, on the contrary, are less correlated to economic cycles. MSCI GICS cyclical sectors are: consumer discretionary, financial, real estate, industrials, information technology and materials. Defensive sectors are: consumer staples, energy, healthcare, telecommunications services and utilities.
  • Duration: A measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates, expressed as a number of years.
  • Duration times spread: It is the standard method for measuring the credit volatility of a corporate bond and is calculated by multiplying the spread-durations and credit spread.
  • Equity risk premium: refers to an excess return that investing in the stock market provides over a risk-free security such as US Treasuries.
  • FX: FX markets refer to the foreign exchange markets, where participants are able to buy and sell currencies.
  • High growth stocks: A high growth stock is anticipated to grow at a rate significantly above the average growth for the market.
  • Liquidity: The capacity to buy or sell assets quickly enough to prevent or minimise a loss.
  • QE: 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.
  • Quality investing: to capture the performance of quality growth stocks by identifying stocks with: 1. high return on equity (ROE); 2. Stable year-over- year earnings growth; and 3. low financial leverage.
  • Reaction function: A function that gives the value of a monetary policy tool that a CB chooses, or is recommended to choose, in response to some indicator of economic conditions.
  • TIPS: A Treasury Inflation-Protected Security is a Treasury bond that is indexed to an inflationary gauge to protect investors from a decline in the purchasing power of their money.
  • Value style: refers to purchasing stocks at relatively low prices, as indicated by low price-to- earnings, price-to-book, and price-to-sales ratios, and high dividend yields. Sectors with dominance of value style: energy, financials, telecom, utilities, real estate.
  • Volatility: A statistical measure of the dispersion of returns for a given security or market index. Usually, the higher the volatility, the riskier the security/market.
  • Yield curve control: YCC involves targeting a longer-term interest rate by a central bank, then buying or selling as many bonds as necessary to hit that rate target. This approach is dramatically different from any central bank’s typical way of managing a country’s economic growth and inflation, which is by setting a short-term interest rate.
  • Yield curve steepening: This is the opposite of yield curve flattening. If the yield curve steepens, this means that the spread between long- and short-term interest rates widens. In other words, the yields on long-term bonds are rising faster than the yields on short-term bonds, or short-term bond yields are falling as long-term bond yields rise.

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