Potential opposition from the ‘Frugal Four’ countries to the EU Recovery Fund, relatively lower growth in the EZ and its EPS growth differential vs. the US point to a limited short-term upside for EUR/USD. |
Rising appetite for EUR, but too early for a bull runCurrency markets have had a clear winner in H1 2020: the USD. While the Fed’s intervention in fact removed the cyclical support from the rates advantage the greenback has had since rates normalisation started, the flight to quality and USD liquidity needs took the lead and kept pushing the currency away from fair value. Valuation doesn’t always work, especially when global growth is collapsing and visibility remains very low. This is when the safe-haven nature of the USD became paramount, therefore sentiment and investor flows were the main performance drivers. It would have been surprising to see the USD moving substantially lower when the preference for USD duration and low beta markets (i.e., the S&P 500) was so accentuated. But lockdown measures are being eased globally and CBs’ strong commitment, together with some ambitious policy initiatives at national level, have already started pushing growth expectations higher, thus providing a framework for valuation to perform and for the USD to finally take a step back. Moreover, the EU Commission’s proposal for the Next Generation fund (EUR 750bn, financed by mutual debt issuance and consisting of a mix of grants and loans), intended to ensure that the long-term prospects of the EU remain intact, is substantially lowering the tail risk of a Eurozone (EZ) break-up. We acknowledge that the event could prove to be a medium-term game changer for the EUR (as debt sustainability issues across member states, de facto, fade). However, in the short term, we remain sceptical about saying that we are at the beginning of a EUR bull market, versus the USD in particular. The downside risks have diminished and should prevent a further collapse in the EUR, but sentiment has so far been the only driver supporting the EUR/USD rally in early June. Even assuming that the EU Commission’s proposal does not find any material obstacles to its approval, the potential pitfalls are still in place (with the “Frugal Four” countries’ potential opposition at the top of the list and many details on the allocation and sizing still pending). These issues could cause another gyration in risk sentiment. The EZ is still without short-term cyclical support (it remains among the few regions/countries expected to grow less than the US in next 12 months) and the month-to-date rally looks overdone given there are few short-term drivers. Physical commodities and the differential in its EPS expectations vs. the US suggest that things need to get worse before they get better, and would point to little short-term upside vs. USD (see chart). In our opinion, the cleanest way to play such a shift in sentiment towards the single currency would be against the British pound. The UK seems to be experiencing the worst economic consequences in the G10 and the no-deal Brexit risk has materially increased with the EU’s Commission proposal. The probability of a further extension in the transition period should be lowered substantially if we consider the increased contribution to the EU budget that all the member countries (UK included for the time being) will be asked to provide once the plan is approved. We see EUR/GBP moving higher in the short term as both positive sentiment for the EUR and the need to hedge the no-deal outcome will provide support. 
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We remain conservative as markets, especially equities, are pricing in perfection. |
Market euphoria clouding the need for cautionOver the past month, we have witnessed changes on two key fronts: (1) an orderly reopening of economies; and (2) strong fiscal support in the US and important policy actions in Europe, where we believe that the EU Recovery Fund and national fiscal interventions could prove to be a short-term game changer. However, there are no signs of improvement on a third front, the sustainability of corporate earnings. Consequently, we maintain our defensive, balanced and diversified risk stance, and believe investors could play some tactical rotation opportunities in the value and cyclicals sectors, green themes and the US consumer area, which remains supported by fiscal plans. Liquidity buffers are paramount at this stage. High conviction ideasOn DM equities, we remain conservative and vigilant on hard data, but see tactical opportunities in Europe (a reduction in the political risk premium) in value, utilities related to renewable energy and industrials exposed to green initiatives. In the US, value, banks, credit cards, industrials (recovery exposure) and discretionary names, including autos, look attractive. However, growth names in the software and internet, staples and utilities sectors in the US are expensive. Our view on EMs remains neutral, with a regional preference for China, South Korea and Taiwan, due to their sector exposure, strong stimulus and better contagion containment. Valuations in some ASEAN countries (Thailand, Indonesia and Philippines) are attractive but we are cautious on some countries due to virus concerns. Overall, it is important to hedge global equity exposure. On duration, we adhere to our close-to-neutral view on the US owing to the current curve control environment and the Fed’s stance of not hiking policy rates until 2022. The Fed will prevent long-term yields from rising too much to avoid tightening financial conditions. We are monitoring the US 5-30Y curve, which we believe is quite steep considering the fundamental economic picture and the Fed’s policy, but is still driven in the short term by sentiment and partly by technicals. Fed buying (especially in the short- to medium-term segments), safe-haven demand and the global search for yield, although to a lower extent, enable us to maintain a preference for US 5Y vs. German 5Y. In addition, UST yields still have room to fall if the Fed signals an openness to negative rates. We are positive on US inflation bonds (medium term), due to depressed valuations and long-term reflationary forces. Euro peripheral debt should be supported by the ECB’s actions (recent PEPP expansion) and the EU Recovery Fund. The latter should reduce the risk premium on peripherals and, collectively, both are putting a ceiling on Italian yields. As a result, we now prefer an outright Italian BTP position over a relative Italy 30Y vs. Germany 30Y position. The former is also less correlated to equities. Amid continued CB support, we retain our constructive stance on credit, and prefer IG (better valuations) over HY and EUR over US (high leverage). Investors should have a well-diversified exposure across sectors (cyclical, defensive, financial senior debt) with a particular focus on high-rated debt of A, A+ and BBB+ grade. However, liquidity assessment and some protection in HY is important (default risk). We are neutral on EM debt. The gap between IG and HY countries is declining, with HY spreads strongly compressing but still attractive, while IG has now reached levels more in line with historical averages. In EM FX, we are now constructive on some high yielding currencies as they are benefiting from sentiment, flows and the focus on improving growth dynamics, but some risks factors (oil war, US-China tensions) remain. Risks and hedgingHedging in the form of gold, JPY/USD (safe haven) and derivatives is important to mitigate the risks related to earnings, insolvency and geopolitics. |
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Spreads are tightening and default rates at the moment are low — compared to previous recessions — due to unprecedented CB-infused liquidity. This calls for high selectivity in terms of sectors and names. |
Markets addicted to central banks: focus on qualityUltra-accommodative CBs and strong fiscal support continue to gradually normalise market conditions, leading to a rebound in risky assets and causing USD weakness. However, as markets are now addicted to CB support, there is a risk of an increase in credit defaults when this support fades. Therefore, in their search for yield, investors should ensure that they don’t go too low in the credit quality spectrum because the risks are asymmetric. Instead, this is a time to remain selective and active, and maintain liquidity and headroom to manage allocations tactically. Investing in green strategies will be a key way to navigate markets. Global and European fixed incomeWe refrain from making any strong calls on duration and keep our stance close to neutral, with a constructive bias on the US and France and a negative view on bunds. We see curve-steepening opportunities on the long end of the US and Euro (10-30Y) yield curves as there is room for long-term yields to increase in light of the massive issuance programmes. The continued ECB support and the prospect of the EU Recovery Plan now allow us to be positive on the Euro periphery debt. On inflation bonds, we maintain a slightly positive outlook owing to attractive breakeven valuations, but don’t expect a substantial increase in inflation (slow economic recovery). We are slightly more constructive on credit amid investors’ search for yield in the low-rate environment. In IG, we are positive on financials and on subordinated debt, in particular, and find selective opportunities (re-leveraging) in TMT, energy and other cyclicals. HY should remain supported by recent backstop announcements from CBs. However, investors should remain cautious and maintain high cash levels due to concerns over debt and the low visibility on earnings. US fixed incomeMarkets have stabilised due to stimulus-driven liquidity, but they are underpricing the downside risks. We acknowledge the optimism, but think it’s crucial to maintain cash buffers. In credit, demand is driving spreads tighter. We are constructive, particularly on the long-duration credit of quality companies with stable cash flows (financials, industrials, consumer sectors). Consumer and housing markets are demonstrating resilience and, accordingly, we are positive on non-agency RMBS and see value in subordinated and esoteric ABS. We are cautious on the UST 10Y owing to rich valuations and concerns over rising fiscal deficit, and believe the yield curve is likely to steepen, with longer-maturity yields rising due to a pick up in economic activity and increased issuance. TIPS offer inflation protection from a medium- to long-term perspective. Agency mortgages offer liquidity and the prospect of higher yields, but selection is critical as the securitised market may lag the recovery and subdued employment could impair consumer spending and debt repayments. EM bondsWe favour HC debt, but valuations are starting to look less appealing. We are more positive on HY (Serbia, Ukraine) as valuations are attractive and spreads could compress further vs. IG. But we are more cautious on rates, given the strong performance of Russia, Mexico and Egypt. In LC, selectivity and curve positioning is required. It is also important to consider the US elections. FXIn DM, we are cautious on USD in short term and are now positive on EUR/USD. In EMs, we are constructive on commodity and high-beta currencies amid reopening and oil rebound. 
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. |
Faith in central banks is lifting equity markets. A rotation towards cyclical themes could offer some opportunities in markets priced for perfection. |
Central bank support is driving sentimentOverall assessmentMarkets are pricing in the narrative that the worst is behind us, leading to a strong rebound in equities and meaning implied expectations are no longer depressed. However, as uncertainty remains amid subdued economic data, US elections and geopolitical tensions, it is important for investors to remain highly selective and focus on high-quality names. At the same time, some positive signals of reopenings in the US and the Recovery Fund in Europe play in favour of a rotation towards value and the cyclical space that could benefit in the recovery phase. European equitiesOverall, we are cautious after the strong rally and believe in maintaining strong liquidity buffers and reassessing our cyclical bias, with a focus on resilient, non-disrupted business models and balance sheet strength. There are rotation opportunities in value stocks in banks (prefer banks vs. insurers), amid the progress on the EU Recovery Fund. But the focus should be on names with strong capital positions and profits. It is also important to pay attention to liquidity around small caps, where the situation is more fluid. At sector level, we recommend a barbell approach, with exposure to both defensive areas (for example, resilient yet attractive sectors such as healthcare) and cyclical areas (quality cyclical stocks in luxury and building materials), which will benefit from an economic recovery. We are cautious on technology, due to high valuations, and consumer discretionary (autos), owing to the combination of structural and cyclical challenges. In all cases, agility is required and we continue to focus on process discipline and stock selection, as well as tightly managing market, factor and style risks. This allows us to selectively look for dislocations after any market correction. US equitiesUS equity has showed strong resilience during the Covid-19 crisis. Importantly, while the economy is hampered, around two-thirds of the S&P 500 is made up of companies in sectors that had a positive/neutral impact from the shutdown (technology, healthcare, communication, staples, etc.). The economy is reopening quickly and valuations are fair outside the few large concentrated stocks. We see a leadership rotation in favour of value and recovery stocks, where we like high-quality names with robust balance sheets and some secular advantage. We look for such attractively valued companies in financials (mega-cap financials), industrials, traditional consumer cyclicals (communication services) and commodity cyclicals. We believe cyclicals could display better performance in case of a recovery but require a thorough fundamental analysis. On the other hand, we are defensive towards bond proxies (staples and utilities) owing to their unsustainable valuations, and are avoiding expensive growth stocks. The valuation differentials between growth and mega-cap stocks are extreme. From a market-cap perspective, a shift down the market-cap spectrum within quality in large caps could offer selective opportunities. EM equitiesWe are slightly more optimistic on EM equities but remain cautious, and believe policymakers’ actions will be supportive of a global growth re-acceleration. We are cautious on the US-China relationship as potential sanctions might be detrimental (for China and the whole EM universe). EM equity valuations look more attractive vs. DMs, but the earnings outlook is still challenging. We are positive on Russia and India and search for more value and cyclicality in sector allocation (industrials, discretionary, materials). 
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