Equity Letter - Bric-a-brac and tipis

The economic and commodity cycles are not over, but their magnitude today is nothing compared to what we have experienced over the last two years, with the boom and bust story. One of the reasons why cycles are now expected to be less pronounced is (unfortunately) because we are more reliant on public spending (not always friendly for long-term growth potential) to maintain growth stable at just a decent level. At the same time, we are counting much more on domestic demand to play a key role in the coming years. This is true for both DM and EM and if we remain in the EM sphere, this time around it is the TIPI (Thailand, India, Philippines, Indonesia) which seems to offer the greatest protection.

Trade deceleration and rising populism are a fact, and in this context our challenge is to find a way to maintain growth at a decent level in order to find a narrative which will be different from the one we experienced last time in similar circumstances.

Romain Boscher, Global Head of Equities

During this period, it made sense to buy emerging markets as a block, for which an apt emblem was BRIC (Brazil, Russia, India, China) comprising the four biggest emerging economies, or even BRICS for those who wanted to include South Africa in the podium of the top five.

Then occurred a major if not THE great financial crisis which brought an end to the hegemony of global trade. One of the consequences was the discovery of uncharted territories such as the ZIRP (zero interest rate policy) which helped to avert or at least to defer the worst, but at the same time contributed to growing inequalities The other very material consequence was the end of the commodity super cycle. We suddenly discovered that the new frontier dividing markets was defined by commodities, with the commodity exporters, the BRACS (Brazil, Russia, Australia, Canada, South Africa) being the most exposed to the energy-related industrial recession (cf chart above). The dividing line was no longer determined by the EM/DM status but rather by the status of commodity importer or exporter.

In the same vein, the earnings revision momentum (net upgrades as a percentage of revisions), which was regularly in the red for years, has become more neutral, reaching its highest point since H1 2014 for Emerging markets, H1 2015 for Europe and H2 2015 for Japan

Is this earnings turnaround credible, knowing that for years, the usual pattern was a drastic attrition of EPS forecasts over time?

If a 12% EPS rise for 2017 is probably too demanding, we could well end up with a high single digit growth figure. This remarkable achievement should be facilitated by the clear rebound of the earnings power of the Energy sector, which has been hammered since mid-2014. More specifically, the Eurozone should benefit from lesser Fx headwinds, after the resurgence of emerging currencies since 2015, and possibly from improved conditions for its ailing financial sector

Ibra Wane, Senior Equity Strategist

What does the end of deflation mean for global equities?

The main consequence of a Trump Presidency is likely higher inflation. His fiscal expansionism will accelerate a trend that was already becoming visible in the US: a gradual uptick in prices and a modest move up in inflation expectations. Trade policy may exacerbate this in a negative way: pragmatic Trump is “inflationary” but populist Trump is “stagflationary”. We think that pragmatic Trump is the most likely outcome and the associated inflationary uptick will have an important impact on the market overall (initially at least, positive) and has the potential to drive an accelerated sector rotation.

In our view, the most obvious beneficiary is the financial sector which has suffered significant damage to its profitability through a combination of low rates, flattened yield curves and much tighter regulation. An uptick in inflationary pressure and higher nominal growth will provide some welcome relief to net interest margins and perversely may lead to banks acting as more effective credit transition mechanisms as they become less fearful of the future and some of the distortions of a period of ultra low interest rates begin to unwind. Valuations are so depressed that any increase in expected profitability will likely lead to a sharp rerating. Although cyclicals generally should also benefit, valuations here already reflect a more constructive environment so the performance opportunity from a move away from disinflation is probably more muted in these sectors than in financials.

Following the election of Donald Trump, market expectations for US inflation have started to increase as potential import tariffs, fiscal push (tax reduction and infrastructure spending) and the ousting of illegal emigrants are by nature inflationary. A steepening of the US yield have been ensuing, which is not favorable for emerging currencies. We would point out though that emerging economies’ current accounts are in better they were shape than they were during the Fed QE Taper Tantrum in 2013, which should help mitigate the impact while yield remain more attractive un EM than DM. One should also bear in mind that some base metal prices could benefit from a strong investment program in the US which is a stark difference with the last US dollar strength episode.

The last couple of years were characterized by uncertainty and alternating risk-on/risk-off episodes. Furthermore, as a consequence of historically low interest rates, classic diversification between Fixed Income and Equity no longer works. Hence, investors need to find alternative solutions to make their equity portfolios more resilient and less volatile.
In this context, Amundi devised a new strategy called “Equity Protection Overlay” which aims to mitigate equity drawdowns and reduce the overall portfolio volatility, while retaining equity upside exposure. This option based solution can be customised in order to best fit the client’s objectives and constraints (protection levels, geographic allocation, regulatory constraints, …). It was first implemented for a French institutional client one year ago on the Euro Stoxx 50 and the S&P 500.
Derivatives can be used in multiple ways for hedging purposes. While a “buy & hold” approach by investing in put options / futures contracts is simple to implement, it can turn very costly in stalling or slowly rising markets. Amundi’s solution is based on dynamic management of options in order to optimize the efficiency of the strategy while reducing the costs. The key to success of our solution depends on the choice of the options’ maturity, the holding period and the notional calibration.
This solution combines two legs. The first leg is a systematic and permanent protection dynamically managed. It consists of buying mid-term put options or put spreads on equity indices depending on a market risk indicator. The second part of the strategy is a financing leg. It is based on selling short-term out-of-the-money call options. This leg aims to reduce the cost of the protection leg and enhance the portfolio risk-return- profile, at the expense of a capped upside participation.

We first implemented the overlay on the Euro Stoxx 50 in October last year. The strategy works in line with our expectations and outperforms the index by 5.7%.

It reduces both the equity drawdowns (by 40% on average) and the overall volatility of the portfolio. Indeed, the realised volatility of the Euro Stoxx 50 is 23.5% year-to-date while together with the protection strategy it presents a volatility of 14.5%.