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Global Investment Views - June 2020

 

Auteurs

 

 

 

 

 

Header

The great market detachment from reality

The dichotomy between the false market tranquillity and the high level of uncertainty about the length of the crisis and its long-term implications is striking. In our view, we are far from being out of the woods and investors should stay alert as current market levels are still pricing in a ‘too rosy too soon’ endgame. The race between the three cycles will continue. On the pandemic cycle, markets have been relying on the narrative that the worst may be behind us in Europe and the US, with rising expectations of contagion curve-flattening. If these hopes are not realised, market tensions will resurface. On the economic front, the huge fiscal and monetary measures are like an insurance policy for the next six months, but should the recession prove worse than expected, markets will need more and any disappointment will trigger a correction. ‘Credit’ is becoming addicted to CB action; market conditions have improved but not normalised. On the credit default cycle, critical in a world that will see even more debt after the Covid-19 crisis recedes, markets have already priced in a first round of defaults but not a second one for traditionally laggard assets. The battle between liquidity and solvency will continue and US commercial real estate is an area to monitor. The disconnect between market hopes and economic and pandemic reality reinforces our conviction that now is a time to remain cautious: don’t chase the bulls, but gradually and selectively play investment themes better positioned towards a slow road to recovery. Reasons to be vigilant, on top of the uncertainties in the three cycles mentioned above, are: First, a resurgence of the US-China rivalry, amid the ‘blame for the virus’ game, was the main risk that re-escalated in May. Second, the outcome of US elections is uncertain. Third, EM are facing high idiosyncratic risks (Brazil). Finally, the long-term consequences (retreat in global trade, rebalancing of policies in favour of labour, transformation of business models, and acceleration of trends, i.e. smart working) of Covid-19 are complex and remain under scrutiny. During the unprecedented last 3 months, our focus has been: the dual objective of protecting investment capital from any permanent loss and having room to add to emerging investment opportunities. This attitude remains unchanged and investors should focus on the following:

  • Liquidity: This is precious in managing transition from the deepest phase of the crisis to an uncertain recovery. The crisis has made clear that liquidity should be a key metric of portfolio construction, despite recent signs of improvement. In fact, the depth of liquidity in credit markets remains thinner and more expensive than prior to Covid-19. Investors should keep some liquidity for defensive and aggressive strategies, so they can reposition in some areas of market when opportunities arise.
  • Positive stance on IG credit: This should benefit from CB actions and the primary market can offer opportunities. However, investors should remain very selective at the sector and company level, focusing on good balance sheets and businesses that can withstand the economic lockdown.
  • Conservative risk exposure to equities amid further EPS growth revision: Any catalyst for improvement must come from a vaccine or a potential treatment because only these factors could trigger a permanent recovery and positive change in consumer behaviour.
  • Cautious on EM in light of rising geopolitical risks, with opportunities to watch in credit as well as in Asian and Chinese equities, but the evolution of the China-US relationship is key (recent tensions could derail market sentiment). The credit market is discounting an aggressive rise in defaults, but investors should consider that many of the most troubled stories have already traded down to their distressed recovery levels and some are currently even restructuring. Investors should identify those companies that can successfully draw up a plan to emerge from the distressed status.
  • Covid-19 is an accelerator of growing importance of ESG: While the E and G will remain high on the priority list, the societal focus towards higher social equality, fair treatment of employees and care for their health will underpin the growing dominance of the S component. There will be greater scrutiny of the ways companies act in the interest of all stakeholders and the community. This will translate into a greater impact on stock prices of some ESG risk factors, which will provide opportunities for active managers, in both the equity and bond space.
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June 2020

Flag-FR

Juin 2020

 

 

 

 

1. Auteurs Macro Strategy

 

While CBs engaged in unconventional policies on both occasions – now and in 2009 – this time the valuations are so extreme that a bull market driven by multiples expansion seems unlikely.

Equities: a bear rally or a meaningful rebound?

The big question we are debating is: should we raise the allocation to equities and chase the market rally or not? While we maintain our strategic preference for risky assets, we are convinced it is tactically safer to stay in the IG space (supported by central bank umbrellas) given that we believe a relapse in equities is due, as explained below.

The economic backdrop has rapidly deteriorated: both hard data and economic momentum have reversed, hurting risk sentiment. We recognise that the medium-term recovery scenario that will probably play out later in 2021 provides significant potential upside. However, equity markets are anticipating the upside scenario now, at a time when profound uncertainties persist. These uncertainties relate to health care policies around treatments. While testing and vaccine are on a fast learning track, a lot still needs to be done. There is no clarity on a timeline for availability of a treatment or a potential vaccine.

On the fiscal side, full capacity has to be tested and maintained in the medium term: the speed of implementation is choppy, spending quality still needs to be assessed (in terms of composition and targets), and capacity (of fiscal packages) to recover from the damage has not been fully estimated.

On the other hand, central banks – after having dealt with the 2008 financial crisis – were quick to respond this time and allowed financial conditions to ease, particularly in the US. This was the most convincing factor for the markets to move higher and multiples to expand. This is where we detect the dangerous inconsistency of falling earnings per share generation and total returns moving higher.

Conversely, bond yields and oil prices remain depressed, and the rebound has not benefitted cyclical areas that much. Earnings revisions are pointing sharply down to historical lows, pushing P/E ratios back towards their peaks. The chart below explains our rationale for current caution. In 2009, we saw a profit recession and central bank efforts paved the way for a full asset reflation regime to play out. Today, valuations (P/E percentiles for 2020 earnings) are completely different, with all the major equity indices already at peak. In fact, an MSCI US valued in the 84th percentile (in the blue bubble) may not offer the best possible case for upside. This is the major difference between the situation now and in 2009. In the latter case, P/Es were already in their low percentiles (grey bubble) and the unconventional monetary policies of central banks allowed upward movement in equities. The only exception to this is the TOPIX, which is in a lower percentile now and shows more reasonable valuations. One could argue that this is because Japan is already in a recession, but compared to other advanced economies, a later but smaller shock is likely, with Covid-19 outbreak being largely contained. The unprecedented lockdowns and monetary and fiscal policy responses help us maintain our ‘strategic’ preference for risky assets, but high valuations don’t provide the best possible upside. To close, we would say that unconventional monetary policies have once again reflated asset prices. However, when compared with 2009, current earnings per share are depressed and P/E levels are so extreme that a bull market driven by multiples expansion is unlikely.                                                                                                                                                                  

2. Graphique Macro Strategy
titre-multi-asset
Author 3

 

 

We maintain our defensive stance on equities; positive view on credit and on peripheral bonds as supported by Central Banks action

Manage risk dynamically; avoid following the bulls

The economic backdrop is characterised by global recession and sequential slowdown, followed by de-synchronised recovery paths across countries. The length of the weakness, the extent of permanent output loss, and of demand destruction will depend on the duration of lockdowns and the effectiveness of the fiscal/monetary push. We confirm the scenario of growth stabilisation around Q4 2020. Throughout the crisis, we have focussed on active management of risk exposure – protecting credit positions, keeping hedges in place, and prioritising quality of holdings and credit selection.

High conviction ideas

We remain defensive on European and US equities because of tight valuations and ambiguity regarding the impact of Covid-19 on global growth. The consensus for 2020 earnings growth has corrected, but it still remains too optimistic for 2021, in our view, despite low visibility. In an environment in which risk remains clearly tilted towards the downside, we wait for markets to provide better entry points (the 2650-2700 level is the trigger for the S&P 500) to act and change our current stance. We maintain a neutral view on EM as market volatility remains high, but continue to prefer China, South Korea and Taiwan due to strong stimulus and relatively better containment of the virus.

We have a neutral stance on duration, as we believe central banks will aim to keep the cost of public debt low to support governments’ fiscal needs, leading range-bound movement in for yields. A Treasury yield of around 60 bps is consistent with the Fed’s stance and a sharp worsening of the macro picture. We remain constructive on US 5Y vs Germany 5Y, as USTs should benefit from safe-haven flows (although to a lower extent than in the past) and Fed purchases, especially in short- to medium-term segments. Regarding US inflation, we are now positive on a medium-term perspective and believe inflation swaps and TIPS breakevens are trading well below their historical averages.

As we exit the pandemic, reflationary forces, such as deglobalisation and debt monetisation, should support higher inflation risk premiums and demand for inflation protection.

The search for yield continues on the Italian curve, as it offers relatively attractive yields. We maintain our constructive stance on Italy 30Y vs Germany 30Y and are now positive even on Italy 10Y BTPs, as ECB actions are helping to put a ceiling on yields and spread volatility. The German court ruling represents a downside risk; however, the ECB is unlikely to change course. We maintain our stance, as it could provide balance to investors’ portfolios.

With a focus on liquidity, we are still constructive on credit, supported by CB umbrellas in the US and the Euro area, but we prefer IG to HY. EUR HY could suffer from high default rates and slowing top-line growth. Accordingly, we are very defensive.

Given the high uncertainty and divergence of fundamentals and valuations, we have a neutral view on EM debt and see a gap between IG and HY countries. In external debt, the IG sector should remain more resilient in the coming months. HY, however, presents a binary risk/tradeoff between default risk for distressed countries and a catch-up from very depressed valuations. On local rates, the main driver for debt is the currency exposure and we believe room for further compression is limited.

On DM FX, we are no longer constructive on the EUR/CHF, owing to safe-haven status of the franc, high money supply growth in the Euro area, and the German court ruling which could pressurise the EUR. We maintain the NOK/EUR position, as the Krone has already corrected significantly and is a way to benefit from a more optimistic scenario.

Risks and hedging

Hedging instruments in the form of the JPY, derivatives and gold remain key to protect portfolio returns in this phase of high uncertainty.  

 

3. Tableau Multi Asset
titre fixed income
Author 4

 

We look for market dislocations and also strive to stay away from names that won’t withstand this crisis. This is even more important as the BBB market share has increased substantially

Credit quality is key

Over the past month, we have seen a gradual improvement in market conditions after massive price and liquidity dislocation in March, but we are still not back to normal. Investors should remain cautious, continue to maintain sufficient liquidity, and be mindful of potential rating migration which could cause volatility in credit markets. On the other hand, they should try to make tactical adjustments in order to benefit from market events – for instance, if there are attractive issues in the primary market – without changing strategic convictions.

Global and European fixed income

We have an overall neutral stance on duration, with a constructive view on the US and cautious ones on Japan and Germany. Investors can take advantage of yield curve movements (curve flattening in US, Europe, UK; steepening in Japan). While we remain positive on Euro peripheral debt, we are more cautious but still constructive on Italy (strong investor appetite as €22 billion raised recently through BTPs). Concerns on German court ruling and increased debt burden are balanced by Franco-German proposal for a sort of ‘recovery fund’. On credit, US IG (we recently became more positive on this segment) and EUR IG remain well supported by CB actions, but credit selection and quality are important to distinguish issuers who will make it through the crisis vs those that will become insolvent. We like subordinated financials, telecoms, pharmaceuticals and insurance, but are cautious on US energy. Bond issuance in the US has been concentrated in IG borrowers and on BB-rated corporates (Fed’s decision to include fallen angels and HY ETFs in its programme). We have confidence in BB sector, but search for qualityis key here. Activity in US HY has resumed (demand exceeded supply) but activity is muted in Europe. However, investors should exercise caution.

US fixed income

Securities and sectors with limited prospects for price appreciation, such as insurance-linked securities (which have delivered 2% returns YTD) and AAA consumer and commercial real estate securitisations, have been resilient and may provide opportunities to serve as funding sources for long-duration IG corporates and some HY credit at deep discounts. We remain positive on RMBS outside of the AAA-rated tranches, as their spreads grind tighter but are overly discounted. Being careful to maintain adequate liquidity, investors should hold positions in UST, TIPS and US government agency mortgage bonds, and cash. In addition, this is a time to consciously pare back idiosyncratic risk when liquidity and pricing afford opportunities. Spread tightening in leveraged loans may enable investors to exit BB names at prices near par, and improve liquidity and quality while extending credit duration.

EM bonds

We are mindful that the Covid-19 crisis is weighing on global growth and corporate earnings, with negative effects on EM outlook, pushing many countries into recession. We have been cautious on names dependent on exports, commodities and tourism. Portfolio hedges and liquidity remain important. On HC, we are positive, particularly on HY (Ukraine). There are opportunities in primary market to gain exposure to IG names at discounted levels (Mexico). We are cautiously constructive on local rates in Mexico and South Africa, and positive on Russia.

FX

In DM FX, we are positive on the USD and JPY, given their safe-haven status, and are less negative now on the CHF but cautious on the EUR and GBP. On EM FX, we are defensive.

4. Graphique Fixed Income

GFI= Global Fixed Income, EM FX = Emerging markets foreign exchange, HY = High yield, IG = Investment grade, CHF = Swiss Franc, EUR = Euro, USD = US dollar, UST = US Treasuries, RMBS = Residential Mortgage Backed Securities, ABS = Asset Backed Securities, HC = Hard currency, LC = Local currency, TIPS = Treasury Inflation-Protected Security, GFC = Global Financial Crisis of 2008, JPY = Japanese yen.

titre equity

 

Dividends are now likely to be pro-cyclical because they will reflect the environment in which companies operate, as the latter will be accountable not only to shareholders but also to society

Author 5

 

Low earnings visibility calls for caution

Overall assessment

As governments ease lockdown measures and the world gradually moves out of the Covid-19 crisis, we are likely to see ballooning government debt, low interest rates and economic growth, a rise in the importance of ESG (especially the S factor), growing inequality, political fragmentation and increased geopolitical tensions (US-China, EU unity). We observe a stark contrast between ‘market sentiment’ and ‘economic fundamentals’. While it is important to note that policymakers can provide short-term liquidity, the demand recovery also depends on fear and confidence. This in turn could still impact earnings and long-term corporate solvency. Investors are forced to navigate this situation with exceptionally low forward visibility in an environment with potentially a wide range of outcomes.

European Equities

Overall we urge caution, given the heightened level of uncertainty and deteriorating fundamentals. It is crucial to maintain process discipline, focus on stock selection, and ensure appropriate liquidity levels. We continue to favour balance sheet strength and believe investors should balance near-term risks with medium-term opportunities through extensive use of scenario analysis. Opportunities exist and we suggest investors to apply barbell strategy with exposure to attractive stocks in the defensive sectors (utilities, health care, consumer staples) on the one end and non-disrupted and discounted cyclical sectors (luxury, construction) on the other. In addition, identifying some structural winners in some accelerating trends, such as e-commerce, will be key in generating long-term returns. From a style perspective, there are selective opportunities within value in non-disrupted cyclical areas.

US equities

US equities remain one of the best long-term asset classes in the world, and the outperformance continues to build in these conditions. We expect the market consolidation that started in mid-April to continue. In terms of convictions, we believe the winners will continue to win. Investors should avoid the sector/stocks that are under extreme short-term pressure, including airlines, challenged retailers, cruise lines, high fixed-cost and low-margin businesses, and commercial real estate. Instead, we think investors should focus on sector leaders with sustainable businesses in an ESG integrated approach. This approach proved to be right during the correction and we recommend investors continue to follow this path. Sustainable companies with market-leading positions win when market conditions are tough. Now is also a time for investors to marginally start adding cyclicality to their portfolios, as low volatility is overpriced. At a sector level, we prefer financials, communications services and industrials while we are cautious on consumer staples, utilities and materials.

EM equities

We are focusing on countries at a later stage of the coronavirus cycle (China, Taiwan, Korea) and less vulnerable names within stories of resilient domestic growth and progress in structural reforms (EMEA, India). While there could be headwinds as global uncertainties remain, skillful bottom-up selection, a careful top-down assessment, and liquidity management can help investors weather the current storm. In conclusion, although we prefer to maintain an overall cautious stance for the time being, our outlook is constructive for EM assets in the medium term – as long as the risk of a second wave of infection does not materialise.

5. Graphique Equity

 

 

Asset Class Views

 

 

Definitions

  • 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.
  • Breakeven inflation: 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.
  • Credit spread: 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.
  • 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 cyclicals sectors are: consumer discretionary, financial, real estate, industrials, information technology and materials, while defensive sectors are consumer staples, energy, healthcare, telecommunications services and utilities.
  • Dividend yield: Dividend per share divided by the price per share.
  • 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.
  • ECB: European Central Bank
  • FX: FX markets refer to the foreign exchange markets where participants are able to buy and sell currencies.
  • Inflation swap: An inflation swap is an over-the-counter and exchange-traded derivative that is used to transfer inflation risk from one counterparty to another.
  • Liquidity: Capacity to buy or sell assets quickly enough to prevent or minimize 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. QT: Quantitative tightening is the opposite of quantitative easing.
  • Solvency: is the ability of a company to meet its long-term debts and financial obligations.
  • Sovereign bond: A sovereign bond is a debt security issued by a national government.
  • Stop-loss: A stop-loss is an order placed with a broker to buy or sell a security when it reaches a certain price. Stop-loss orders are designed to limit an investor’s loss on a position in a security.
  • TIPS: Treasury Inflation-Protected Security is a Treasury bond that is indexed to an inflationary gauge to protect investors from decline in purchasing power of their money.
  • VIX: VIX is the CBOE volatility index. The VIX index is a measure of market expectations of near-term volatility on the S&P 500 (US equity).
  • 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.
  • Quasi sovereign: companies wholly or partially owned by the government.
  • Yield curve flattening: A flattening yield curve may be a result of long-term interest rates falling more than short-term interest rates or short-term rates increasing more than long-term rates
  • 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 yields on short-term bonds, or short-term bond yields are falling as long-term bond yields rise.
BLANQUE Pascal , Group Chief Investment Officer
MORTIER Vincent , Deputy CIO, Asia ex Japan Supervisor
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Global Investment Views - June 2020
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