The ECB and the Fed delievered the same message: they are ready to act "if necessary". |
Central Banks: seeking to extend the cycleThe ECB and the Fed delivered the same message: they are ready to act "if necessary". Their tones contrast with the current economic conditions. Domestic demand on both sides of the Atlantic remains resilient, particularly household consumption, which still benefits from good labour market performances. True, the manufacturing sector and global trade are both at half-mast and business investment is expected to slow in the US. And we've been observing for a few years that the correlation between industry and services tends to diminish. That said, more pressure on the manufacturing sector implies higher risk that weakness will spread to the economy as a whole. This is CB’s fear today, in addition to inflation, which is too low at this stage of the cycle. The ECB has revised its economic forecasts,but at the margin. The stronger-than-expected growth in Q1 gave the bank the opportunity to raise its figures for the Eurozone in 2019 (from 1.1% to 1.2%); on the other hand, it revised its forecast for 2020 down (from 1.6% to 1.4%). The ECB is concerned about the weakening of inflation expectations. Companies do not have enough pricing power to pass on wage increases in selling prices. The combination of subdued growth, falling inflation expectations and increased downside risks explains the ECB's tone. Opening the door to a rate cut is intended to prevent the euro from appreciating "by default" (if the Fed were to lower its key rates sooner than expected). Opening the door to a new securities purchase program is intended to maintain very accommodative credit conditions. Finally, the generous terms of the TLTRO-IIIs are intended to guarantee the banks cheap funding for an extended period of time. On the Fed side, the bias has clearly become accommodative with the disappearance of the term "patience" in the bank’s statement of 19 June. The economic outlook ‒ even if business investment is expected to slow further ‒ does not fully justify the rate cuts that are priced in by markets. And, Chairman Powell was very careful not to feed such expectations. But a possible increase in protectionist tensions between the US and China is being taken very seriously by both the Fed and the ECB. The Eurozone is about twice as sensitive to world trade as the US. A fall in global demand can therefore be accompanied by unwelcome disinflationary pressures if the euro appreciates at the same time. The ECB is now expected to clarify its intentions and forward guidance at its next Monetary Policy Committee meeting (25 July). The next FOMC (31 July) could also be an opportunity to give some more clues regarding Fed’s policy. Finally, while trade-related risks are explicitly mentioned by the ECB and the Fed, both CBs fail to highlight what growth owes to the increase in public and private debt. To ensure the solvency of indebted agents, there is nothing like keeping interest rates artificially low (i.e. well below nominal GDP growth) ‒ in addition to the fact that by containing the debt burden, monetary policy opens up opportunities for a complementary fiscal stabilisation, if needed.
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DM= Developed Markets, EM = Emerging Markets, CB = Central Bank, ECB= European Central Bank, Fed = Federal Reserve. |
ECB dovishness make Euro IG credit eve more appealing. |
Time to play central banks and politicsWe still call for a late cycle environment with extra dovish central banks. Growth concerns and trade disputes continue to be the key risks which darken the outlook. On trade in particular, although we still expect a deal between US and China will be eventually reached later in the year, we do not expect any near-term solution. Uncertainty may remain high with regards to geopolitical risks. High conviction ideasGiven this backdrop, we maintain a defensive stance on equities, as the risks of negative EPS revisions remain high and we prefer to seek value by playing key themes, such as: divergences in growth and central banks policies, and politicsrelated topics. In fixed income, the Goldilocks scenario induced by accommodative CBs remains our central case, and we do not expect recessions in the coming months. Therefore, we believe that the “hunt for yield” theme remains front and centre. Hence, we increase our preference for corporate bonds ‒ in particular in the investment grade space ‒ which is backed by strong technical factors and the low rates environment. Here, we prefer Euro corporates to US, due to better fundamentals and favourable technical trends against expensive USD hedging costs. On rates, we revised our forecasts down, and keep our preference for 5Y US vs 5Y Germany; we also remain negative on the German short end (2Y), where we don’t see any value left. In the UK, the weaker outlook for growth, combined with nominal rate vulnerabilities to sharp sell-off, supports our defensive stance on UK real rates (10Y). In Norway, a strong domestic economy is still supporting the central bank’s hawkish stance, compared to a more dovish stance from the ECB, which is still facing downside economic risks. Thus, we continue to prefer the NOK vs the EUR. In playing relative value opportunities, we prefer the Italy-Germany 10Y spread versus the 2Y spread, as we believe it offers more interesting carry and has more potential for tightening. A political theme we are currently playing is the possibility that Trump could withdraw from NAFTA by presidential notice. This could increase pressure on the Democrats on one side and on Mexico on the other. We express this trade risk theme via currencies with a positive view for USD vs CAD. We do not expect the ratification process to be completely derailed, but we would like to be protected if the negative scenario materialises. EM markets in general continue to remain an area of interest, especially as the threat from US rates and a stronger dollar dissipates. In GEM equities, we have a neutral stance overall, but we maintain regional preferences, such as Korea and China, which could benefit if visibility around trade negotiations improves or as a domestic demand story. On EM Bonds, with an income focus, we continue to seek selective opportunities, favouring hard currency to local currency. On the GEM currency space, we have a preference for IDR, BRL, RUB vs ZAR. Risks and hedgingThe market continues to be focused on the risks of a trade war (US vs China, but also vs the Eurozone, Mexico, Canada) and other geopolitical issues (tense situation in the Gulf of Oman) and their impact on the growth outlook. We suggest maintaining some hedges through a preference for the Yen vs USD, which should outperform in case of a further escalation in geopolitical risks. 
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GEM = Global Emerging Markets. |
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Markets have gone too far in pricing in aggressive Fed cuts. This increases the risk of disappointment. |
Expect rates swings on monetary policy uncertaintyWe see two key themes driving fixed income markets: 1. The potential impacts of a trade war on growth prospects and 2. The Fed’s and the ECB future dovish policy stances. The two themes are strictly interconnected as they drive market expectations on CB policy moves, with CB on their side watching out for growth evolution and financial conditions to reassess their policy mixes. The implications appear to be a strong push on yields towards record-low levels, with markets in our view too complacent on future FED cuts and a continuation of a more volatile regime on bond markets. It is paramount to be ready to tactically adjust duration views, play curve opportunities and seek carry with a selective approach to avoid areas of complacency and poor fundamentals or unrewarded liquidity risks. DM bonds
We expect US Treasury rates to stay supported, due to the increased downside risks to growth and the low visibility on trade issues which, in our view, encourage a prudent approach. We see some value in TIPS. Despite the recent weakness in inflation data, an escalation of tariffs will tend to boost near-term inflation, a concept that is currently completely off investors’ radars: market measures of inflations expectations (eg, inflation breakeven) are at extreme lows. CreditCredit is well remunerated on the basis of current outlook, but we recommend a selective approach, with a preference for the short end of the credit curve and favouring Euro IG. In the US, given the increased risks, we continue to recommend a ‘careful carry’ posture that involves reducing overall risk and moving up in quality. Within government-quality sectors, we view Agency MBS as especially attractive relative to nominal Treasuries. We continue to play the strong fundamentals of the consumer sector within the structured securities’ space. EM bondsDespite recent trade tensions, performances for both EM local and external debt were positive, benefitting from a tightening in spreads. Potential FED cuts this year and the lower-for-longer yields in DM should favour EM assets. We like EM local duration (Brazil, Indonesia, Russia and South Africa) as we think that EM rates can perform well in different macro scenarios due to anchored inflation expectations. We are still cautious within EM LC, especially in lowyielding, China-sensitive economies in Asia, but our outlook has tactically improved, given a stable US dollar. FXThe USD remains one of the highest yielding among the main DM currencies and could offer some protection against trade escalation. We stay cautious on the Euro. On EM, we favour some Eastern European and LATAM currencies (BRL and RBL), while staying cautious on Asian ones (KRW, TWD, SGD) more vulnerable to protectionism. 
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TIPS = Treasury Inflation Protected Securities |
In the search for yield, some bond proxy stocks have become too expensive on both sides of the ocean. Despite cheap valuations, value sectors are not a buy per se, but a selective play. |
Play quality cyclicals, stay away from “bond-proxies”Overall assessmentThe equity rally was capped early in May on renewed concerns about US tariffs, but after the pullback, the equity market quickly recovered, staying close to all-time highs. What is peculiar regarding this market is that flows have not accompanied the rally of the first months of 2019, and this is especially true for DM equities. In an environment of low rates and a prolonged long cycle, with deteriorated but stabilising macro fundamentals, we believe that equities could continue to be supported, based on interesting valuations (in some segments), low investor positioning, and potentially supportive factors further extending the cycle (dovish monetary policy and areas of supportive fiscal stance in Europe). Nevertheless, with uncertainty still high, the market will continue to be vulnerable. Volatility and valuation dispersion could offer opportunities for active stock picking. DM EquitiesEuropean markets look more attractive vs the US based on valuations: the Brexit saga, Italian political situation, exposure to trade issues, and low growth have contributed to Europe being unloved. This perception could change with a Brexit deal and with some improvement on the US-China trade front. We don’t foresee earnings growth driving European equities from here into the next year. Earnings growth is probably set to continue to be revised downward, although not equally across sectors and names. This environment plays well for selecting opportunities among and within sectors. Overall, we prefer cyclicals vs more defensive segments, which, in our view, have become too expensive. We like high-quality industrials with strong balance sheets, some of which discount very negative outlooks, and we see opportunities in healthcare as well. We find tactical opportunities selectively within European banks which on the whole are trading at extremely depressed valuations. The negative story on European banks is well known, but implied expectations are too low in some of the higher-quality core European banks. In the US, the value segment is at the cheapest levels since the tech bubble and the financial crisis. In order to have a strong performance of the value sector, we need reflationary conditions which are not visible in the current phase of the cycle. But the heavy short positioning and the extreme valuations suggest a preference for at least some segments of the value space, in particular: quality cyclicals with long-term growth characteristics, but priced for a recession; retailers relatively insulated from pressure from online sellers; mega cap banks that have been regulated into stability and that have the scale and technology to win. Among our strongest convictions, we believe that “bond proxies” stocks are extremely overvalued (e.g. some consumer staples and utilities stocks). EM EquitiesAt this juncture, we think the US-China trade issue remains the main trigger that could either boost or negatively affect the asset class. Despite a still-constructive outlook for EM equity supported by our expectation for a deal to be finally reached (at least partially) and earnings stabilisation, we expect short-term volatility. Therefore, we have turned slightly more defensive on China for the time being. We focus on markets where valuations look set to remain supportive and where idiosyncratic risk is less pronounced, and avoid sectors most exposed to possible tariffs. 
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