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Equity Letter - Bric-a-brac and tipis

The essential

Emerging markets offer a perfect illustration of the economic and financial transformations that we are currently experiencing. For decades a more open world order under the umbrella of an expanding WTO had fuelled expansion in global trade making it a major and powerful growth engine which had succeeded in pulling millions of citizens out of poverty in the emerging market world.here some desirable segments may create bubbles.

 

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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.

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CONVICTIONS

The end of downward earnings revisions?

Regarding EPS growth, after a flattish period since years, the IBES consensus currently expects a +12% rebound for the MSCI World AC in 2017. This sanguine view is reinforced by the fact that, over the last three months, these forecasts have been almost untouched, if not revised up, like on Emerging markets.

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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.

 

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TOn the other side of this inflationary divide are the so-called “bond proxies”, stocks with low growth but regular and visible cashflows. Higher inflation and higher nominal growth will make their growth profiles less attractive and at the same time higher discount rates will erode their multiples. The market is heavily invested in these stocks which have been stellar performers since the 2008 crisis: this could potentially drive a sharp rotation as investors adjust portfolios. There are very limited value arguments for many of these stocks at the current time.

Healthcare stocks are somewhere in the middle: usually they would be classic candidates to de-rate as growth picks up and discount rates rise. This may yet happen but the electoral cycle and concerns about political intervention in US healthcare have already led to a large de-rating: whilst higher inflation in the future may yet lead to further declines in healthcare multiples these stocks already look good value. We think that they offer attractive alpha opportunities and have the benefit of offering diversification as the market adjusts to a new political era in the US and potentially to an end to disinflation and ever lower yields.

Nicholas Melhuish, Head of Global Equities

What does the Trump election and the end of deflation mean for emerging markets?

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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.

As for the impact of change in trade policy, we believe the improving activity outlook of emerging countries in aggregate should not be derailed by a new US import policy that will take time to be implemented and trickle down to the rest of the world. US policies under a Trump administration could result in an acceleration of the slowdown of global trade, which was already in progress. We expect higher import tariffs on selected Asian countries, such as China, which could be directed at some selected sectors.

Finally, Trump’s election could bring additional changes to the geopolitical relations of the USA. In particular, relations with Russia could improve while the one with the Middle East and China could deteriorate further. Meanwhile, the increasing political risk of developed countries make the case for emerging equities even more compelling where, broadly, there is no worsening of political situation, while regions such as Latin America have seen their political outlook improving..

Patrice Lemonnier, Head of Emerging Market Equities

FOCUS

Equity Protection Overlay celebrates its first anniversary

Against a backdrop of aging demographics, slower consumption and a high debt stock, Japan continues to draw interest as a laboratory on how to tackle the economic challenges of our time. Translating those challenges into investment themes deemed to be effective in the long run, either through higher sales or higher return on equity, can offer a strong proposition for investing into Japanese equities. In the last article of our series, we introduce two new promising investment themes along with illustrations of two companies.

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.

 

 

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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%.

 

Being customizable, this solution has raised interest over the past months, not only in relation to equity portfolios, but also for credit portfolios as well as among insurance companies needing to optimize their Solvency Capital Requirement (SCR). Indeed, Amundi has recently been entrusted with a new Overlay Protection solution which has been adapted to optimise the equity SCR. Many possibilities can thus be offered.

Kamal Chancari, CAIA Convex Solutions Portfolio manager

Sabine Duchesne
Stephan Eckhardt
Investment Specialists

BOSCHER Romain , Co-Head of Equities
MELHUISH Nicholas , Chief Investment Officer, Equities – Amundi London
IWANAGA Yasunori , CFA, CIO Amundi Japan
HO Anthony , Chief Investment Officer - Asia ex Japan
DRABOWICZ Alexandre , Deputy Head of Equity
ANDRE Sudeshna , Investment Specialist, Equity Strategies

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Equity Letter - Bric-a-brac and tipis
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