Most surveys have continued to deteriorate over the recent period, indicating that the bottom of the cycle has not yet been reached. There are also early signs of weakening on the side of services. But overall, the global economy is resisting the manufacturing recession. While investment in capital goods is affected by uncertainty in many countries, household consumption continues to benefit from job creation (although it has started to slow).
Not surprisingly, global trade remains at half-mast. The restart will be slow. It will take much more than a front agreement between China and the US to bring down the level of uncertainty which weighs on business investment. The ratio of world trade to world GDP is thus expected to continue to decline by the end of 2020.
Growth will slow further in advanced economies in 2020, particularly in the US. And China will also continue to slow down. However, the growth gap between emerging and advanced economies is expected to widen in favour of the former. Against this backdrop, we believe that the world economy should stabilise by the first half of 2020 at the latest. Nevertheless, downside risks continue to dominate: on the one hand, there is political risk. On the other hand, there is market risk: a sudden repricing of risk premiums would tighten financial conditions and thus weaken the most indebted agents (starting with corporations).
The uncertainty is there to last. It should be noted, however, that the epicentre of political risk is gradually shifting from Europe to the US: the Italian government has finally opted for a measured fiscal programme; and the probability of a hard Brexit has fallen with the agreement reached on 17 October. In contrast, in the US, political noise related to the impeachment procedure, coupled with polls in favour of Senator Elisabeth Warren for the Democratic nomination is beginning to attract investors' attention.
In this context, and in the absence of inflation, central banks will remain pre-emptive. On the ECB side, the publication of minutes and the positions of several heads of the core Eurozone central banks show that the dissent has never been so pronounced since the creation of the ECB, which reduces the probability of further easing. The priority for Christine Lagarde (who will take office at the beginning of November) will be to bring the various central banks together again. On the Fed side, the monetary strategy will be opportunistic. The dissensus is also very pronounced. In recent weeks, markets have sharply revised their expectations downwards, both on the Fed side (-60 bps expected by the end of 2020 vs. -125 bps a few weeks ago) and on the ECB side (-10 bps expected by the end of 2020 vs. -40 bps a few weeks ago). Market expectations are now more in line with our central scenario.
While manufacturing data continue to deteriorate,
In the future, central bankers will increase pressure on governments to take over from monetary policy with a more accommodative fiscal policy. Many emerging countries have already relaxed their fiscal policies. The advanced economies should gradually follow suit. In the Eurozone, we can count on Christine Lagarde to remind governments of their duty.
USTW$= Trade-weighted US dollar, a measure of the value of the US dollar relative to other world currencies. CNY=Chinese Yuan. SEK= Swedish Krona. AUD= Australian Dollar.
Amid a structural deterioration, we believe it is better to stay cautious, but be ready to tactically adjust the risk stance. We are constructive on EUR credit.
The bottom of the cycle has not yet been reached and further slowdown can be expected both in Europe and the US. The former would be more impacted as it is a more open economy and accordingly countries such as Germany are under pressure from trade tensions. This trade weakness, coupled with weak domestic consumption, could see risks spreading from manufacturing to the consumption side.
However, we don’t read this as the beginning of a recession. Instead, we believe two closely linked themes would likely play out in the near future – uncertainty on interest rate movements and ambiguity on market directionality, amid an ongoing deterioration in the macro-economic environment. In addition, from a (geo)political perspective, the situation is mixed with a new government in Italy, signs of an end to the Brexit saga and the US President Trump’s impeachment that could still potentially impact market sentiment.
Therefore, now is not the time to increase risk. Instead, we prefer to remain cautious, maintaining a flexible approach, as a rebound cannot be ruled out.
High conviction ideas
Against this uncertain background, we outline three areas of conviction across asset classes.
(1) Low visibility on future earnings suggests a cautious stance on equities. The relative value between equities and bond is shrinking, but it is too early to adopt a fully defensive stance. Instead, we think investors should be flexible and adopt option strategies to tactically adjust exposure and benefit from a potential market rebound. This is because stabilising PMIs could support equities, particularly in the cyclical sectors such as energy and consumer discretionary, both in the EU and the US, but directional bets are probably still too risky. Sector rotation could also present opportunities, as could domestic themes in EMs, in particular in China.
(2) The hunt for yield will continue as the amount of negative yielding bonds is at historical highs. Expectations that Italian government will maintain fiscal discipline provide a positive backdrop for Italy 30y BTPs vs Germany 30y. On corporate bonds, we prefer EUR vs US and are now more constructive, tactically, on EUR HY (primarily for carry) on account of a benign default outlook, limited supply and dovish ECB. On EM bonds, the overall financial conditions (in EMs) which include attractive carry, dovish global central banks and subdued inflation in the developed world, are all supportive of the search for spread exposure in this space. In currencies, we believe investors should continue to seek carry opportunities in the EM FX space, where some positive developments on the US-China trade front led us to adjust our selection.
(3) Markets are counting on central banks policy actions which are supportive. Here we remain positive on duration, but have adjusted some of our views on UK 10y real rates and Schatz, which will continue to be supported by the ultra-dovish ECB. We remain constructive on US duration in view of an accommodative Fed, and hence prefer US 10y and US 5y vs Germany 5y.
Risks and hedging
Global recession, trade war uncertainty, failure of central banks to act and a downturn in Eurozone are all risks that could impact multi-asset portfolios. As a result, we recommend investors to put in place structural hedges such as JPY and gold to safeguard against an extreme downturn.
We expect the economic slowdown to continue, but nor recession. This underpins a positive stance on credit in Europe, and on sectors exposed to the consumer side in the US.
While the global economy is witnessing a slowdown, we don’t expect a recession. In the US, consumption and services which are a large part of the US economy, should provide support. However, uncertainty over the ongoing trade war and manufacturing weakness lead us to expect a dovish stance from central banks. Therefore this is a time to be cautious but not too conservative. We believe investors should stay in credit to exploit carry and be selective because the appetite is high and this could lead to areas of market complacency. In this environment, should be selective, well diversified and focused on liquidity.
From a global fixed income perspective, we remain neutral on duration but with a preference for duration in the US compared to the Eurozone and Japan. We continue to favour the UK curve steepening strategy, extending the long end of the UK yield curve and we expect a flattening on the Euro curve, while in the US we continue to play curve opportunities. In Europe, a dovish ECB supports our favourable view on EUR IG credit, but we are negative on utilities and adjusted our outlook for the financial sector. We remain watchful of some idiosyncratic risks in high yield (HY). For sovereign bonds, we are constructive on peripheral European countries and slightly more positive on Italian BTPs now, given the improving political stability.
From a US investor perspective, the 10y Treasuries appear expensive as investors’ continued to search for safety amid uncertainty on trade front and lower ISM data. However, given the strength of the services sector, the consumer and small businesses, the Fed is likely to evaluate data before additional monetary easing. Hence, in our view the US duration exposure should be limited.
On US credit, we maintain a modest risk stance and focus on sectors that offer exposure to the domestic US consumer and allow us to enhance diversification in areas with attractive relative valuations. Accordingly, we remain positive on asset-backed securities (ABS), commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS). Agency MBS securities are also attractive. We also continue to expect a steeper treasury curve and we have a slightly positive stance on Treasury Inflation-Protected Securities (TIPS) given a higher likelihood of upside inflation surprise (from wage growth and tariff related).
Although we think the asset class can be a net beneficiary of the tug of war between weaker growth and looser monetary policy, we prefer to maintain an over all cautious stance for the time being. Looking at fundamentals, Latin American countries are relatively more attractive at the moment but we are carefully looking at the commodity outlook, which could weigh on this area. We turned more constructive on Brazil (local currency and corporate), while we have reduced our positive stance on Indonesia and Russia.
Given the liquidity and attractive yield offered by the USD and the protection offered by the JPY, we are positive on both these currencies. We also prefer a relative value trade NOK vs SEK, in light of the Norges Bank’s hawkish views. The rate disadvantage and the ECB easing measures are a burden on the Euro. We are neutral on the GBP. EM FX should remain weak in this environment given that they are most exposed to global growth.
NOK = Norwegian krone. SEK = Swedish krona. JPY = Japanese yen. GBP = British Pound.
Sector rotation has opened up attractive opportunities in quality value, with a preference fr cyclicals.
All in all, strong directional bets in equity markets may be too risky in the current environment (economic slowdown, uncertain global trade), however, active investors should keep an eye for opportunities presented by appealing areas of the market. Valuations of value vs growth are extremely attractive and this is leading some initial signal of a reversal in the multi-year trend of outperformance of growth vs value. We are actively watching such pockets, but we are extremely selective as we note that companies that do not meet expectations in the current uncertain environment, get overly punished by the market. Going forward, we believe investors should look more and more at the equity market with an income perspective. In a world of ultra-low/negative bond yields, the dividend from equity is extremely attractive.
In Europe, there is an all-time high dislocation between value and growth and this dislocation provides investment opportunity. Value stocks trade at an all-time low levels relative to growth, and we think the former provides an attractive hunting ground for stock picking. In particular, the areas that have relatively higher quality and are less exposed to disruption are interesting. Such opportunities exist selectively within sectors such as building materials, industrials, consumer discretionary and financials.
However, we are cautious on the very high valuation of certain pockets of the growth universe. The current reporting season shows that there is little room for error when the high valuation names within growth disappoint, therefore caution is needed. At the portfolio level, we continue to seek balance. For this we prefer health care and telecoms in the more defensive compartments over consumer staples as the first two sectors offer a better margin of safety. We also look for emerging opportunities in the UK domestic sector which is trading at depressed levels.
In the US, equity valuations remain attractive relative to fixed income, but the global slowdown and government policy uncertainty suggest a more prudent approach. While earnings growth in the upcoming season is expected to be weak, a crucial indicator would be the guidance for the next quarter and 2020. We are more constructive on value over growth. Despite challenging macro data and headlines (i.e., trade, impeachment, Warren presidency), cyclicals/value are compelling on relative valuation and sentiment suggests risk is to the upside right now. Therefore, this is not a time to be overly defensive. From a bottom-up perspective, we believe high-quality cyclicals could provide opportunities in case of an upside.
In the EM space valuations are supportive and the market could benefit in case of a mini-deal on the trade front. We remain broadly positive on domestic consumption countries for the next few months (such as Brazil, Indonesia, Russia and India) and turned moderately constructive on China even though we expect some volatility in the near future.
At a sector level, we favour information technology (especially in Korea and Taiwan) and the energy sector where valuations and free cash flow yield are very attractive.