In absence of
The outlook is somewhat more uncertain than last year due to the rise of protectionism, but we must not sink into an excess of pessimism. The global economy is resilient:
That said, the climate of uncertainty is not conducive. The global manufacturing sector is at half mast. The countries most heavily involved in global trade are taking the biggest hit. Against this backdrop, the world economy is slowing this year. We expect about half a point less global growth YoY in 2019, with growth of 3.3%.
In the absence of inflation and given the downside risks, central banks are implicitly committed to maintaining accommodative monetary conditions. So far we have maintained a status quo for our fed funds rate estimate in 2019/2020, in line with our own GDP growth and inflation expectations. We have increased the probability of the downside risk scenario (from 20% to 25%) and recognise that risks have become asymmetric (in line with markets’ expectations).
Some Fed’s member already argue that a simple disappointment on inflation rate / inflation expectations could justify a cut in the fed funds rate regardless of GDP growth (i.e. even if growth remains close to potential, with no risk of recession). The implicit idea is that the neutral rate (r*) may be a little weaker and that the Fed has gone too far in terms of rate hike last year. James Bullard (President of the Fed of St Louis) – while recognising that the normalisation has been successful and that the “stopping point” is appropriate – recently argued that a cut might also be appropriate if inflation disappoints. We have maintained also a status quo for the ECB. The ECB would not hesitate to mobilise the available tools if the need arises. All of this will help keep interest rates low for governments and corporates, and thus contain the debt burden.
For their part, governments will not remain inactive if GDP growth slows further. There is less and less opposition to the mobilisation of counter-cyclical fiscal policies in a structurally weak interest rate environment. As the center of gravity of the global economy will continue to shift from West to East, we should not focus our analysis only on short-term. The world of tomorrow will benefit from multiple sources of growth. Global value chains are re-regionalising or even re-nationalising, which means that going forward we should benefit from economic cycles that are less dependent on each other at the global level.
The strategist’s view – US / China trade disputes shake markets
Since Trump’s first tweet threatening to add tariffs on Chinese goods from 10% to 25% on the 5th of May, markets moved into full risk-off mood: equities sold off, core rates rallied, high yielding/high beta currencies took a hit. Core rates have benefitted from their safe haven status and went lower: US 10Y touched 2.40%, and the German Bund is back to negative territory (both yields are back to the lows of March end). The US curve steepened (2Y10Y) as markets are back to increasing the odds of getting a cut on rates from Fed by 2019 end (the probability has moved from 50% as of post 1st of May FOMC to 75% as of 14th of May). In the G10 currency space, the USD was impacted negatively as, due to its current high-yielding currency status, it suffered the unwind of FX carry trades, to the benefit of reserve currencies like JPY, CHF and EUR. Further escalations of US/China disputes could exacerbate the aforementioned moves, in particular on the USD front as current positioning (both on the speculative and real money side) is rather elevated on the long side.
In EM, volatility has been quite high after the latest news on trade talks. Further escalation would affect not only China but also markets more linked to the global cycle and, among them, some relevant Asian markets such as Korea and Taiwan. Our key call is for China not to devaluate RMB to face higher tariffs and eventually not to overshoot the 7.0 level. Other EM FX are undervalued but, in case of escalation and RMB devaluation, they will be strongly impacted, in particular the Asian FX like the Korean Won and Taiwan Dollar. EM FX volatility has been quite high YTD, mainly for the high carry currencies that usually react strongly in a risk-off environment. In our view, EM FX volatility will remain high also because of some idiosyncratic stories like Turkey and Argentina that are politically related.
DM= Developed Markets, EM = Emerging Markets, CB= Central Bank, ECB= European Central Bank, Fed= Federal Reserve.
In a late financial environment, we are maintaining an overall cautious stance on risk assets, with a preference for credit vs equities. Those elements that, a couple of months ago, suggested some risk reduction in our positioning, are still present (Brexit, growth concerns in China and escalating trade disputes). We believe current equity levels are discounting very high expectations regarding a deal between US and China. Therefore markets remain vulnerable to a tactical pull back, given the ebb and flow of negotiations. Weaker momentum in the global expansion and world trade are expected to continue into the summer. Risks are skewed to the downside as a combination of geopolitical and idiosyncratic hazards increases the uncertainty on the policy reaction front and may further dampen growth.
High conviction ideas
We remain cautious on DM equities: while the easy financial conditions and the light positioning of institutional investors in Europe represent a good support for the market, many factors suggest a defensive stance. Since the beginning of the year, the undervaluations gaps have mostly closed, and global equities are priced at fair value now, profit cycle has passed the peak – although we still expect single digit growth in 2019. Moving on to economics, the global situation remains fragile and exposed to further negative surprises. We express this caution through a defensive stance regarding Europe and the US market. We have moved to neutral view on EM equities, where we prefer a country specific / relative value approach, in light of the lack of visibility on on market direction. In EM, we prefer more cyclical markets – Korea for example which could benefit from a mild rebound in the cycle in the second part of the year, and exhibits interesting valuations compared to the rest of the EM.
We continue to like China, particularly the domestic sector, which should benefit from the recent fiscal and monetary stimulus. Investors could also play EM divergences in the currency space, preferring for example currencies with positive carry (ie a basket of Indonesian Rupia, Brazil Real and Russian Rouble), vs shorting high beta currencies (South African Rand). This offers a way to keep volatility low while exploiting relative value opportunities.
In fixed income, we reccomend continuing to exploit carry from credit, where we still prefer Euro IG over US IG, given the better fundamentals. We also find a better risk/reward profile in IG vs HY securities. While we have revised down our rate projections, we believe investors should keep low duration risk. We don’t expect core European bond yields to fall below current levels, especially in short-term maturities, as the ECB is not expected to cut rates further unless the Eurozone economy deteriorates sharply, which is not our base case scenario. Accordingly, we find more value in 5Y US Treasuries vs 5Y German Bunds. We are defensive on UK 10Y real rates, based on a weaker outlook regarding UK growth, combined with nominal rates being vulnerable to sharp sell-off.
Risks and hedging
The main risks to monitor emanate from the political arena, especially the tensions over trade disputes (US-China, US-Eurozone). The lack of visibility on Brexit, and the imminent European elections are also in focus. Investors should keep hedging strategies in place (to protect equity and high yield bond exposure) and a preference for the Yen vs USD, which should outperform in case of a further escalation in geopolitical risk.
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.
We believe it is
The scenario of moderate growth and dovish central banks remains supportive for fixed income, and in particular for bonds which provide investors with an income - ie corporates and EM bonds. However, as these markets are no longer cheap, it is important to “optimise” the carry opportunities across the board (EM debt hard currency, EU investment grade, US corporates less exposed to trade disputes). We expect US Treasuries to continue to protect portfolios in case of an escalation of trade tensions and other geopolitical risks (resurfacing frictions around the Iran nuclear deal could impact the oil outlook). The price for safety is high, with the 10 Y US treasury yield at 2.4% (10 Y Bund yield in negative territory), but it will likely remain so, as there is strong demand for safe assets and scarce supply. As we expect the US dollar to stay around current levels in the short term, non US-investors could consider gaining exposure to this source of protection and liquidity without a full currency hedging.
Current market conditions don’t justify in our view aggressive duration stances. US treasuries may benefit from uncertainty, due to their “safe haven” status, but the market is quite expensive and it is difficult to see rates going far below the current levels: a 25bps cut for next year is already priced in; we do not expect a cut this year. Inflation expectations are low now and we could see a mild repricing in inflation expectations (due to oil, input prices and wages rising) which could cause a return of volatility to fixed income. In relative terms, we see more value in US Treasuries vs German Bunds. We remain positive on EU peripherals bonds, keeping a flexible approach as the political situation appears quite fragile.
Considering the current economic conditions, carry represents the primary source of return for fixed income investors; investors should maintain a preference for European credit, due to good fundamentals, even if the room for spread tightening is limited considering the strong performance of the asset class since the start of the year. We believe it is appropriate to adopt a “careful carry” position, that involves selectively reducing spread duration and moving up in quality. We see also selective opportunities in the high yield market, especially after the repricing which followed the recent tariff disputes, as the outlook for default rates remains benign.
Increased trade and political risk still suggest a cautious stance on the EM debt sphere. The EM macro story is still intact and we keep our positive view on the asset class over the medium-long term. The recent volatility, while suggesting us the need for a more defensive and selective approach for the time being, likewise may create attractive entry points in countries and sectors. We thus look for tactical opportunities in hard currency debt, which continues to be an appealing source of carry and may continue to perform well at this stage. We also view exporting countries favourably: they could potentially benefit from a global shift in the supply chain; conversely, we keep a defensive stance on currencies more exposed to China growth.
We have our positive view on the USD in the short term and cautious stance on the EUR due to downside risks on growth.
We see a more
The intensification of the trade disputes between the US and China halted the equity bull run. However the correction was limited, the US and the European markets partly recovered from the post-tariffs lows, supported by financial conditions which continue to remain loose, dovish CBs, generally easier fiscal policies and relief from the low expectations on Q1 reporting season. Supporting factors for the market are still in place, but a cautious and selective approach is preferable due to the wide spectrum of geopolitical risks and the less appealing risk/return profile compared to the beginning of the year.
US equity valuations remain attractive relative to fixed income. There are opportunities in quality and growth, but these are very stock- or vertical (i.e., within a sector)-specific. We see value in companies linked to infrastructure/cloud/data centre spending (these stocks sit in three sectors), selective financials such as insurance brokers, and auto & home insurance. In addition to valuations, many of these services stocks have lower foreign input costs that might be subject to tariffs and are also less exposed to potential trade retaliation given they have less non-US sales exposure than goods companies. Services stocks have faster sales and earnings growth, more stable gross margins, and stronger balance sheets. We are now cautious on capital goods, tech hardware, and semiconductors, industries which had been among our preferences in the past few years. Bond proxies, such as consumer staples and utilities, plus staple-like companies with no structural threats in many other sectors, are expensive on a relative-value basis.
European equities could offer interesting entry points after the EU elections, should the economic outlook improve in H2 and domestic demand remain resilient, as we expect. The current features of the market (increasing valuations dispersion, lower sectoral correlation) fit a stock picking approach. We continue to see selective opportunities in the cyclical part of the market (but with less conviction than one month ago), while the defensive part is expensive. Industrial and energy are the high conviction ideas, while on banks we believe a cyclical rebound has to be confirmed to see a convincing repricing opportunity. In the defensive space, health care sector is our favourite choice.
We see a mixed picture for EM equities: relative performance will now largely depend on the development of US-China trade story. A satisfactory deal would be beneficial for EM stocks, as it is not fully priced in at the moment. Given ongoing uncertainty, downside risk are still lurking in the background, suggesting near-term defensive positioning. Global investors are underweight EM, providing a potential technical support to the asset class. Dividend theme is attractive as the dividend per share growth is accelerating in main countries. We maintain our preference for China given the supportive measures related to credit growth rebound and tax cuts. Also some domestic demand growth stories in Asia, more insulated in case of a trade escalation, are attractive as defensive plays.