At a time of scare visibility on growth quality, focusing on GDP data might be misleading. Weak GDP numbers do not exclude profit recessions.
Growth looks likely to remain weak near term amid softer global manufacturing activity and this has been reflected in downward revisions to corporate activity as the reporting season recently highlighted. On a positive note the consumer side remains resilient.
Against this backdrop the four most debated topics within our Research team in order to assess future economic and market directions have been:
Trade war: Notwithstanding some steps forward on trade agreements between US and China, ahead of their September talks, the trade outlook remains challenging and represents the key risk factor.
Central banks: Markets continue to pressure Central Banks to deliver more and more liquidity to suppress financial volatility and set very high expectations on the fiscal side to structurally support the economic cycle. The ECB delivered a meaningful package of aggressive easing measures to support the inflation outlook, while the Fed will pencil its rate strategy on a meeting-by-meeting basis. As (geo) politics, not economic prints, dominates markets movement, this seems to us a reasonable approach.
Financial conditions: Central banks activity will ultimately affect FX, shaping financial conditions. This is a key factor to monitor as it drives corporate earnings cycles. Interest rates and currencies (so called “translation effect” for international sales) impact corporate profits. Currently, financial conditions are a primary source of risk for a profit recession (according to our analysis we attach a 30% probability to this risk event). The deterioration of global trade (due to tariff war) is reflected in the manufacturing and in wholesale sectors. Given that wholesale and manufacturing sectors account for 2/3 of total sales, we might be approaching a turning point. If uncertainty persists it will further chill business investment (the global capex cycle has already halted) eventually hampering job creation and/or preservation. At that stage, the spill over to consumers would be fast. On a positive note, domestic retail sales bode well because they are primarily driven by domestic consumers and are resilient to external shocks.
Chinese growth: The Chinese data just released confirm our views of a decelerating GDP growth on the range floor at 6% YOY in H2 2019 and below 6% YoY in 2020 (at 5.8% YoY). The picture is not as dark as it might appear at a first glance: housing sector, retail sales ex-auto, infrastructure investments have been resilient in their weakness, if not moderately growing (supported by the special bonds issuances). We do expect the authorities will ramp up in their stimulus to accommodate the deceleration mentioned above. More stimulus has to come in the form of monetary policy easing, frontloading of local government special bonds, support for the auto sector (relaxing or removing purchase restrictions) and budget fund. More concessions to the US, on the trade front, should help to alleviate the short term pain coming from the external side, trying to avoid, for example, the introduction of the new tariffs or the increase of the existing tariffs rate (set to take effect on 15 October and December respectively). This latest objective is challenging; however, next trade talks could bring some temporary relief.
MPs= Members of Parliament. USTW= Trade-weighted US dollar, a measure of the value of the US dollar relative to other world currencies
In this phase of slowdown and uncertainty, it is important to remain agile. Investors should consider recalibrating their equity stance to a less underweight position.
Given our scenario of a late cycle environment with extra-dovish central banks and trade risks, we adopt a defensive and agile stance in terms of risk allocation. Our pre-summer view of favouring US duration to de-risk the portfolio has been nicely rewarded by the markets. We stay cautious on equities, although with a tactical upgrade, and constructive on credit, mainly on Euro IG. Strong directional calls may carry excessive risk and we believe it is more appropriate to focus on relative value opportunities.
High conviction ideas
We stick to two main convictions against an economic backdrop that remains weak (but still with no global recession in sight) and dovish central banks. Firstly, we are maintaining a generally cautious risk allocation across the board, as valuations are not cheap and areas of uncertainty persist. Secondly, we think investors should be agile when they see opportunities in the market and readjust their exposure.
On the first, we maintain a selective and cautious view on equities, given pressures on earnings growth, even without a recession. Investors should also continue to consider hedging strategies. However, we have been agile in tactically reviewing and upgrading our view on equities (US in particular) in anticipation of a possible rebound. One way investors could preserve a flexible equity risk allocation is by implementing option strategies. In credit, we favour Euro IG over US IG, as US credit looks too leveraged and pricey compared to fundamentals. In fixed income, we remain positive on US 5y vs German 5y, as we think there is limited room for German yields to fall further given 5y Eonia is already pricing in further rate cuts. We became more positive on US Treasuries, when rates recently returned to back above 1.80% on the 10y. On Italian BTPs we moved our preference from the 10-year to the 30-year, as most of the positive newsflow stemming from the formation of the new government is already priced into the former. However, as this view increases the duration risk, we believe investors should consider to partially hedge the increased exposure. In EM bonds, we believe attractive carry, low US rates, subdued inflation, dovish Fed and EM Central Banks are all supportive of spread exposure (but hedging the duration risk). We keep our positive stance on EMB HC, but we think that Euro-based investors should consider partially hedging the USD exposure given the recent strong rally of the currency. In currencies, we maintain a preference for an FX basket of highercarry EM currencies vs South African Rand and the South Korean Won, and in DM we still like the Norwegian Krone vs EUR (based on a strong outlook for Norwegian economy).
Risks and hedging
While geopolitical events (US-China, Brexit) are hard to forecast, we must assess them in order to manage risks and seek opportunities. We suggest investors remain agile and risk aware as we are in a less-directional market phase. Liquidity risk may also resurface should central banks disappoint. To deal with these risks, investors should run well-diversified portfolios. Secondly, investors should actively hedge risks (using Gold, Yen and US Treasuries) to avoid forced selling during periods of turmoil. Thirdly, “stress-testing” portfolios allows investors to assess the potential effects of adverse market movements. Lastly, cash or highly-liquid government bonds (US duration) may act as liquidity buffers in case of heightened volatility.
With supportive central banks, IG credit continue to offer opportunities, but selection and liquidity management all more important.
Over recent weeks the likelihood of a heightened trade war, no-deal Brexit and a return of Italian political crisis has receded. Against this more supportive risk backdrop, central banks are taking central stage. While, the ECB delivered a comprehensive monetary easing package including rate cuts of 10 bps and an asset purchase programme, and tiering system for banks, markets continue to expect massive monetary easing by central banks that may be unrealistic. All in all, this calls for a flexible approach to duration management and a still positive view on credit, with selection and liquidity management in focus.
In global fixed income, we maintain our neutral view on duration but investors should continue to seek opportunities at curve levels, as well as at the country allocation level, with a long US/short Germany stance for instance. Among sovereigns, we remain positive on the main peripheral European countries (Spain and Italy where we believe investors should consider some profit taking), supported by monetary easing by the ECB and a new coalition in Italy willing to find agreement with the EU commission on the 2020 budget. Regarding inflation, the Euro breakeven rate has picked up following the recent easing by ECB and we see possibility of an additional pick-up. On inflation, we keep a positive view on US break even. In credit, we favour EUR IG credit, where we have become more positive in the financial sector, in particular in subordinated debt financial and senior financials (Europe). Euro credit investors can also seek opportunities in the primary market. The recent ECB move plays in favour of IG credit. From a US investor perspective, the 10y Treasury yield declined inside of 1.50%, driven by risk-off sentiment and a global thirst for yield, and then rebounded, but we still see room for further rebound. Expectations for aggressive Fed cuts are too high in our view. So, we think investors should remain active in tactically adjusting the duration exposure when the market expectations get extreme. We expect the treasury curve to steepen, given the dramatic run in long term UST yields. On US credit, we prefer higher quality carry and lower risk assets. We favour securitised credit over corporate credit on expectations of strength in consumer and services sectors. In this regard, asset-backed securities (ABS), commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS) and seasoned agency MBS pools look attractive. US IG corporate market remains strong. Massive recent corporate bond issuances, both HY and IG, were met with even greater global demand, signalling that the appeal for US assets is still high.
We think investors should become more cautious by lowering duration and increasing the cash levels to address potential lower liquidity. Our top convictions remain Brazil, Egypt, Indonesia, Serbia and Ukraine (due to improving outlook and interesting yields), but we are cautious on China (growth slowdown). In credit, we have been seeking selective opportunities in IG and also HY.
We remain positive on USD and JPY, given that the former provides deep liquidity, safety and good yield, whereas the latter is the main risk-off protective currency. We are negative towards the British Pound (Brexit). The outlook for the Chinese Renminbi and South Korean Won is also weak, in light of the global slowdown and trade frictions.
The breakeven inflation rate is the difference between the yield of a nominal bond and an inflation linked bond, with the same maturity.
With lower visibility on corporate earnings it is important to focus on quality names in cyclical sectors at attractive valuations.
Global economic growth could slow down but a recession is unlikely, in our view, given strong domestic consumption (services) in the US, Europe and the emerging world, and dovish global central banks. While the S&P 500 fell in August, now the markets are back to pre-summer highs. Going forward earnings expectations will decide whether markets break upwards or fall from here. However, earnings continue to be revised down and selectivity remains key to identifying companies with sustainable balance sheets.
In Europe, corporate fundamentals remain solid, although forward earnings visibility has deteriorated. Valuations seem fair and attractive in some areas and we believe heightened volatility and market dislocations (growth/value, cyclical/defensive) could provide investment opportunities. At a sector level, quality/value names are displaying mispricing in industrials and consumer discretionary. We are positive but selective on health care and telecoms as they provide some reasonable safety to an equity portfolio. However, we are negative on sectors such as utilities and consumer staples, which are typically seen as bond proxies, due to high valuations. We see certain opportunities in the domestic sector in the UK, that should be evaluated on a case-by-case basis.
In the US, the consumer remains robust, although the recent spike in oil prices is concerning. Companies may also be affected by oil prices, but it remains to be seen whether this increase is sustained (despite concerns, the supply could be restored and US production has also grown dramatically).
From a style perspective, we are cautious on growth due to high valuations, particularly in the med-tech, software and consumer discretionary sectors.
We are becoming more positive but remain selective on high-quality stocks in the cyclical sectors as valuations are attractive. The outperformance of the defensive vs cyclical may be coming to an end in our view, and perhaps risk on cyclicals are now on the upside. We believe the bond-proxies have high valuations and we remain negative towards them. However, we continue to like good quality opportunities in the real estate sector. In the special value situations space, we are positive on names that offer a mix of value and growth, and where we believe there are improving fundamentals that could lead to a valuation re-rating. At an overall sector level, we are constructive on financials, consumer discretionary and real estate. However, we are negative towards industrials, utilities and information technology.
While we are still constructive on EM equity in the medium term, we prefer to be overall more cautious in the short term, as oil price spikes (drone attack in Saudi Arabia) and trade tensions inevitably have negatively affected the asset class through manufacturing, exports and earnings expectations. Therefore, we would favour self-help countries for the next few months (such as Brazil, Indonesia, Russia and India) and look less favourably on China. As far as the sector allocation, we favour the tech hardware sector in Korea and Taiwan (well positioned to benefit from any uptick in the global economic growth).