Global Investment Views - November 2020 / 11 / 2020 / Amundi Views / Article / Research Center

Bonds are the sentinels in the sequence of recovery

Developments on the virus and vaccine front and the US election are hot topics. Markets are pricing in a glass-half-full scenario, despite the still-alarming infection numbers on the virus front (second wave in Europe and record new cases globally). The interconnection of the three cycles — virus, real economy and financial — continues, but the virus transmission mechanism is changing. The ability of the virus cycle, which is the most critical of the three cycles, to affect the other two is now lower vs the beginning of the year. Today, the world is better equipped with regard to testing and local containment measures and therefore the likelihood of a global lockdown hurting the economy decreases. On the market side, the narrative that fiscal and monetary pushes will continue is preventing any major disruption. Any sign of weakness is viewed to be a buying opportunity.
Phase 1 of the recovery, with virus acceleration: this is where we are today. Any news regarding the trajectory of the recovery is good, but the end of the virus cycle is not yet on the horizon. The positive environment persists based on the strong assumptions of low rates forever and no inflationary pressure. It is true that the sequence in the coming months could be deflationary to begin with, but recovery is under way, thanks especially to China (and other Asian economies) that is further reinforcing its role as the global growth engine. Within this backdrop, equity, credit and Euro peripheral debt markets are responding well. However, in government bonds, volatility has been rising. While the anticipated curve-steepening has started, it is on hold for now. The elections outcome is unclear, and a massive fiscal stimulus seems unlikely.
Phase 2: things have to get worse before they get better, and this means there are aggressive policies to come, especially on the monetary side. This bodes well for a recovery that should further support a rotation towards cyclical themes in 2021. This should favour equities, which could have more upside potential vs HY credit, which could be less appealing on a risk/return basis at current valuations. A rotation from super-high-growth stocks into more cyclical and quality value areas will likely materialize throught in 2021, althout this trend seems on a pause now. Commodity-related trades could also benefit from this cyclical rebound. The availability of a vaccine would be part of this recovery: markets are pricing in availability in mid-2021 and then an economic reacceleration. Any delay could generate volatility, putting the virus cycle once again at the top of market concerns. Investors should look at opportunities from rotation, while also being mindful of possibly higher volatility. Bonds will be the key sentinels for the next phase.
Phase 3: from improving to sustained growth. The next part of the sequence embeds a new round of policy mix and a slow exit from the extreme accommodation seen so far. The measures introduced to fight the pandemic will be very difficult to withdraw, and governments and CBs will probably have to do more. Fiscal and monetary policies will be even more intertwined, making the possibility of further debt-monetisation to finance the recovery a likely scenario. Some EM with weak CB credibility could see inflation rise faster amid their recoveries which could trigger higher commodity prices. This might overheat the economy, ultimately leading to some inflation. This could de-anchor the system, which is based on the assumption of low rates forever, and real rates could become more volatile. This phase will be challenging for risk assets and could favour further rotation into equity value, commodities and real assets.
The switch from one phase to another will not be linear and investors must keep in mind both short- and long-term themes. While on a pause now, with unceranty linked to the US election, next year, the switch from phase 1 to phase 2 will bring rotation opportunities (equity in EM and the more cyclical quality and value spaces), but investors should focus on diversification and selection to counteract volatility. Over the long term, all three phases incorporate some common themes that will be reinforced by the crisis: higher debt, higher inequalities, and a stronger role for China in global trade and economic growth. From an investment perspective, quality and sustainability will once again be key factors to take into account. ESG themes, with a focus on social and green, will become mainstream. Diverging paths in economic growth will emerge. In EM, countries closely linked to China and with higher CB credibility to fight possible inflation surprises will be favoured while other, more indebted countries with fragilities could be challenged. This will make the concept of EM as a whole more outdated and lead to the emergence of global themes linked to the Chinese recovery and cyclical winners.

November 2020

Novembre 2020

We believe that the CNY and, most importantly, the unconventional monetary policy have taken a lead in explaining gold price dynamics.

A glittering environment for gold

Gold prices have been rising since March as policymakers stepped in to support the global financial system affected by the Covid-19 crisis, although recently as the Fed paused its asset purchases, the metal witnessed some correction. Going forward, we believe gold prices will be supported by two main factors: 1) the renewed taxonomy of gold price determinants (discussed later) envisages that CB balance sheet expansion and CNY dynamics would play a prominent role and 2) our conviction for the yellow metal has shifted from a ‘pure hedge’ to an ‘asset class,’ with potential to gain in case of both the downside and the upside economic scenarios.
Over the past few years, we have discussed gold along the lines of its safe-haven nature in the face of increasing geopolitical risks even when rates were rising and in general amid risk-off events. More recently, the (inverse) relationship of gold prices with EMs’ dollar funding and real rates has been progressively enforced. We expect to see further consolidation to higher levels, with $2,100/ounce as a reference for fair value in our radar.
We are still in the grip of the pandemic amid a deterioration of Covid-19-related news flow, which eventually points towards resilient gold prices. Our internal analysis and modelling shed more light on the drivers and sensitivities of the yellow metal, although it is important to note that there is no easy and comprehensive valuation matrix for gold. According to evidence, there are three broad determinants for the gold price:

Economic and real variables (i.e., GDP, inflation, real rates, spreads, among others);
FX dynamics (USD, JPY and CNY in particular) ;
Central banks’ unconventional monetary policies (Fed, ECB and BoJ balance sheet expansion).

As per our calculations, there is a renewed taxonomy and we are convinced that the CNY and, most importantly, the unconventional monetary policy have taken a lead in explaining gold price dynamics.
This ultimately explains the increased correlation with equity prices through a common link – declining real rates that are a side effect of unconventional monetary policy. As we expect the economic recovery to be uneven — requiring active interventions from CBs if growth hits a roadblock or even falls off — and the Chinese economy to lead global growth (which should be reflected in a higher CNY), we believe there is room for gold prices to appreciate further. In the chart below, we show how the different key variables are likely to affect gold prices. Clearly, if CBs continue to maintain their asset purchase programmes and infuse liquidity into the system, it will have, by far, the strongest impact on prices which should rise to around $3,173/ounce. On FX, if we see a weaker USD and a stronger CNY, gold prices are likely to appreciate from current levels.

To conclude, as per our proprietary GREAT framework that measures the price sensitivity of an asset class to macro-risk factors, we expect gold prices to display symmetric price behaviour. This means that in case of both upside and downside economic scenarios, the aforementioned categories/determinants would positively affect gold prices. In fact, should the upside materialise, inflation pressures will likely push real rates down, eventually boosting gold prices. On the other hand, in the downside scenario, we expect CBs to further expand their balance sheets and increase liquidity, likely supporting higher prices for the metal.

We are close to neutral on equities and slightly positive on credit, but are monitoring whether an improving economy and vaccine availability provide better entry points.

Remain conservative and monitor signs of rotations

We see economic recovery as supported by policy initiatives, although there could be downside risks to Q4 growth. This recovery, coupled with vanishing base effects of energy prices, is likely to support inflation in DM. However, the task of generating inflation looks to be tougher in Europe than in the US, whereas in EM, supply shocks are generating pockets of inflation that need to be monitored. Another source of volatility may come from the US election outcome and a resurgence of the virus. Thus, investors should remain vigilant and maintain an active stance. However, when US political uncertainty subsides and there is more clarity on growth and a vaccine, investors may look to cautiously rotate from credit into equities.

High conviction ideas

We deliberately do not change our view on equities at the moment, maintaining a tactically close to neutral stance — defensive on the US (stretched IT valuations) and neutral on Europe. Recovery expectations in 2021, and attractive relative valuations and risk premia, point to an improved case for equities over a 12-month horizon, provided a vaccine becomes available in a timely manner and a surge in infections is controlled. Subsequently, cyclical segments could benefit from a rally. In the near term, higher beta plays, such as US small caps or EM equities, could offer some upside, but timing is crucial. We are constructive on Asia (China and Indonesia), owing to expectations of a more pronounced recovery in the region, higher earnings and better virus containment. Investors should stay active in duration, with a close to neutral stance overall. In the US initial reports from the elections suggest Trump’s performance will be better-than-expected by opinion polls. We are extremely vigilant on the likelihood that Trump holds onto the Senate. That could affect the extent to which the curve steepens. On US inflation, we maintain our constructive view amid the Fed’s average inflation targeting, continuing economic recovery, and debt monetisation tendencies.
We are positive on Euro peripheral debt on the back of ECB support, favourable technicals and the positive impact of the EU Recovery Fund. We maintain our 5Y BTP position, which should benefit from political stability and suffer less in case of a bear steepening of EMU curves.
Although credit spreads have tightened considerably since March, we remain neutral/ slightly positive for the time being in light of the demand for carry and QE support. We favour EUR IG over US IG, due to the combination of attractive valuations, ECB purchasing programmes, and lower leverage in Europe than in the US. Global liquidity and search for yield should benefit EM fixed income. We maintain our positive stance in HC debt, but believe the room for further compression in local rates is limited, with the main driver being currency exposure. Overall, the EMBI spread is close to fair value, with the possibility of spread tightening in HY in the next three months. However, IG spreads now seem to have reached expensive levels. In FX, we remain positive but selective on a diversified basket of EM FX due to attractive valuations, light investor positioning (and rising flows), and potential support from economic recovery. However, investors should tactically hedge this exposure, given the US political uncertainty. On the other hand, the USD looks overvalued over a medium-term horizon and we may see a correction, as the country has lost its growth and high-real-rate advantage vs the rest of the G10 FX. But for the time being, it may be risky to be directionally negative on the greenback, as election volatility could support it. The GBP may be weighed down by the UK’s weak economic activity, although Brexit news flow needs to be monitored.

Risks and hedging

The risks of weak economic growth and policy failure underscore the need to maintain appropriate hedges, to protect equity and credit exposure, in the form of derivatives, the yen and gold. The USD is also a good hedge, if global uncertainty rises.

In a low real rate environment, investors should balance the need to get higher yields with the need to buy quality credit at attractive valuations, all the while maintaining sufficient liquidity.

Focus on carry and security selection in credit

We have witnessed a partial economic rebound in the US, but the extent of permanent job losses there must be watched, whereas leading indicators coming out of China are already above their pre-pandemic levels. However, in Europe, the situation seems to have deteriorated a bit due to a new wave of infections. Overall, we are not convinced that the economy is out of the woods yet. As a result, investors should note that the current crisis is all about avoiding traps and gaining exposure to sectors/names that favour an improving economy and a potential rotation. Having said that, we are cautious with respect to potential volatility related to the US political situation and Brexit risks, and, accordingly suggest maintaining ample liquidity.

Global and European fixed income

With a keen eye for relative value trades, we have an overall neutral duration view, positive in the US (hedge against weak global environment) and France, and cautious on Germany and the UK. Recently improved political sentiment on Euro peripheral countries has encouraged us to remain positive on Italy and Spain. However, amid a new wave of infections which are causing renewed lockdowns, we are cautious on EZ inflation, despite cheap valuations. While we are constructive on credit, we acknowledge that investors face a dual challenge: buying cheap and buying quality credit. This is further complicated by continued central banks/ fiscal backstops that will provide easy liquidity, which in turn is causing some segments of the market to be overpriced. This, coupled with a continuation of fragmentation, increases the scope for security selection in terms of sector and name, with opportunities in financials and subordinated debt, but investors should maintain sufficient cash buffers. Overall, we prefer EUR to the US in IG and HY, due to the lower leverage.

US fixed income

The steepening of the US yield curve could see a pause in the short term, as the prospects of a massive stimulus have faded. We stay cautious on USTs. Markets are not pricing in medical improvements or a potential vaccine. On the Fed side, there is limited room available with respect to how much further low rates can fall from current levels (without overheating the economy), given that real rates are already low and there are already long/medium term prospects for inflation. Therefore, we maintain our positive view on TIPS. On corporate credit, we suggest investors pare back spread duration through active selection. They should also trim exposure to HY cash bonds where risks are asymmetric. On the consumer front, there were concerns that when government support measures expire, the economy would be hit hard. But consumer spending picked up and the housing market and consumer debt servicing remain strong. We see opportunities in securitised credit and consumer and residential mortgage markets, where we favour agency MBS over prime RMBS.

EM bonds

Dollar trends are the key element to watch. In such respect, the worst-case scenario is one of a persistent Dollar strengthening. EM central banks would have to deal with a dilemma between responding to the COVID-19 economic impact and stabilizing their FX and capital markets, leading to higher volatility in EM currencies. Some EM currencies, however, like the Russian Ruble, will show resilience and are likely to outperform in this environment.

FX

We are cautious on USD/JPY, positive NOK/ EUR. The EUR would be weighed on the second wave infection in Europe.

GFI= Global Fixed Income, GEMs/EM FX = Global emerging markets foreign exchange, HY = High yield, IG = Investment grade, 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, CRE = Commercial real estate, JPY = Japanese yen, CEE = Central and Eastern Europe, JBGs = Japanese government bonds, EZ = Eurozone.

The subdued recovery under way could favour a rotation towards cyclical names, but stock selection is critical to identifying resilient businesses with the potential for sustainable returns.

Dispersion may create opportunities for selection

Overall assessment

Economic recovery is under way even if it is not uniform across the globe, as seen in the divergence in the services vs manufacturing sectors. Therefore, in addition to low forward visibility and a wide range of outcomes, investors will have to navigate a phase of imbalances not only in the form of high corporate debt, but also in the form of rising socio-economic inequalities. The current crisis has exacerbated these inequalities. Investors should navigate the current situation with an overall balanced stance.

European equities

While an uneven recovery will cause a high dispersion of returns, it also presents an opportune time for active selection. Valuation dispersion is high and we find great opportunities especially in the higher-quality area of cyclicals, but given the high level of uncertainty, selectivity is required. We have a strong preference for balance sheet strength and urge extreme caution in companies with weak balance sheets and those where business models are being disrupted. In addition, investors need to be careful of areas of excessive valuation, such as technology.

So, on the one hand, we remain positive on healthcare (slightly less so than before) within defensives, but at the other end of the barbell, we find opportunities in cyclical compartments, such as building materials, that are a good way to play the recovery. We also increasingly find attractive names in consumer discretionary, where the risk/reward has been compelling, though one has to be very selective. Overall, we maintain a balanced approach. Another interesting strategy is value, as it could benefit from reflation expectations moving into 2021.

US equities

The uncertain US election outcome, with a likely divided Congress should prevent any major fiscal stimulus. This could pause the reflation trade and the cyclical call. The later will only be posponed untill when a vaccine is available and the economy accelerates.
Even in the case of a Biden victory with a divided congress, we don’t expect any major legislation against the tech sector, that will remain well sustained, in the wake of Covid 19 pandemic.

We like selected quality value stocks that can manage through this difficult economic period and should benefit as the US and global economies rebound and as inflation returns. However, there is uncertainty over the timing of reflation and the potential for a corresponding increase in rates. In addition, certain value-oriented sectors (airlines) are structurally impaired. On the other end of the spectrum, we are constructive on stable growth names, exposed to secular growth trends that are not dependent on economic growth: eg, the shift to online retail. In contrast, we are cautious on hyper-growth and deep value.

EM equities

While a recovery should support EM, US-China tensions must be watched. In Asia, we are optimistic on countries such as South Korea (firstin, first-out). At sector level, semiconductors look appealing whereas high valuations in healthcare and consumer staples make us cautious. Investors should selectively explore cheap names in growth/value, with a focus on those offering sustainable dividend yields or growth catalysts.

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: The 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.
Carry: It is a return of holding a bond to maturity by earning yield versus holding cash.
Correlation: The degree of association between two or more variables; in finance, it is the degree to which assets or asset class prices have moved in relation to each other. Correlation is expressed by a correlation coefficient that ranges from -1 (always move in opposite direction) through 0 (absolutely independent) to 1 (always move in the same direction).
Credit spread: The 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.
Currency abbreviations: JPY – Japanese yen, GBP – British pound sterling, EUR – Euro, CAD – Canadian dollar, SEK – Swedish krona, NOK – Norwegian krone, CHF – Swiss Franc, NZD – New Zealand dollar, AUD – Australian dollar.
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 cyclical sectors are: consumer discretionary, financial, real estate, industrials, information technology and materials. 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.
Equity risk premium: refers to an excess return that investing in the stock market provides over a risk-free security such as US Treasuries.
FX: FX markets refer to the foreign exchange markets, where participants are able to buy and sell currencies.
High growth stocks: A high growth stock is anticipated to grow at a rate significantly above the average growth for the market
Liquidity: The capacity to buy or sell assets quickly enough to prevent or minimise 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.
Quality investing: to capture the performance of quality growth stocks by identifying stocks with: 1. high return on equity (ROE); 2. Stable year-over- year earnings growth; and 3. low financial leverage.
Sovereign bond: A sovereign bond is a debt security issued by a national government.
TIPS: A Treasury Inflation-Protected Security is a Treasury bond that is indexed to an inflationary gauge to protect investors from a decline in the purchasing power of their money.
Value style: refers to purchasing stocks at relatively low prices, as indicated by low price-to- earnings, price-to-book, and price-to-sales ratios, and high dividend yields. Sectors with dominance of value style: energy, financials, telecom, utilities, real estate.
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.
Yield curve control: YCC involves targeting a longer-term interest rate by a central bank, then buying or selling as many bonds as necessary to hit that rate target. This approach is dramatically different from any central bank’s typical way of managing a country’s economic growth and inflation, which is by setting a short-term interest rate.
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 the 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 Group Chief Investment Officer

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Global Investment Views - November 2020