Central banks fuel markets: illusion vs reality

Monday 24 June 2019

Global Investment Views, Fixed income, Equity

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Contributing Authors

Pascal Blanqué
Group Chief Investment Officer,
Amundi

Vincent Mortier
    Deputy Group CIO, 
Amundi

The journey from market complacency to awareness of fragilities is in full swing, and the market correction in May is part of that, as is the recent recovery fueled by dovish Central Banks (CB). Aware investors should recognize that the late cycle phase and mature market trends require improving fundamentals and positive political events to deliver sustainable uptrends in risk assets. But, it is difficult to see such improvements happening in the short term. Purchasing Manager Indices have been declining and what we are seeing is a deterioration in the ‘quality’ of growth. Headline figures of growth are still moderately positive, and not far off our expectations of few months ago, but the composition of growth has changed. Most components of growth are of concern to policy makers beyond the decline in trade growth. We particularly pay attention to the decline in investment growth. However, as far as domestic demand is concerned, it remains healthy, thanks to sound labor markets.

Can this equilibrium hold, given the fragilities overall have increased?

In our view, risk assets will continue to face significant hurdles, with sharp selloffs occurring due to data being below expectations, disappointments related to trade negotiations, and repricing of expectations based on changes in CB policies, which will continue to trigger volatility. In this situation, the behavior of CB becomes crucial again: markets all over the world are currently pricing in rate cuts, with more than 100 bps expected in the US before the end of 2020 and lower rates also likely in Europe, Japan, Canada, Australia and New Zealand. Promises of interest rate cuts and easier financial conditions will likely keep the Goldilocks narrative alive and help markets to avoid persistent downturns in stock prices. However, there are still risks of policy mistakes being made by CB: the line between ‘preemptive’ or ‘reactive’ CB cuts is very thin. While a preemptive Fed will likely be market-friendly for equities, a Fed perceived as reactive, or as starting an aggressive easing cycle, would probably be of concern to investors, as they would start to read higher recession risks in the numbers.

Can we expect there to be any positive developments on this journey?

If our central case is confirmed, the Fed could deliver a preemptive cut this year, responding to risk assets’ appetite for liquidity. With lower rates in the US, China could have more space for monetary policy easing. A stabilization of growth could be possible. Countries in Europe with fiscal space could experience a fiscal boost thus sustaining internal demand. Regarding the US, this will be more of a story post-2020 election. The markets would make a toast if a deal between China and the US is reached, which could happen in the medium term, even if tensions between the two countries continue related to a much deeper and long term geopolitical strategic game.

Setting the unpredictable aside, we focus on what is reasonably predictable ‒ ie, a further extension of this extra-long cycle ‒ and we build our investment strategies around the following convictions:

  • A positive stance on credit and spread products. Search for yield is definitely in focus, thanks to the refreshed CB dovishness. We keep a cautious and flexible approach to avoid areas of fragility;
  • A constructive stance on EM Bonds. EM continue to be supported by the Fed dovishness and expected USD weakening. Here the focus on vulnerability (investing in the less fragile countries) will be key at this point of the cycle as weaker demand from DM tends could affect some EM;
  • A moderate defensive stance on equities. Lacking strong fundamental support, we prefer to play the Goldilocks scenario via credit. That said, the European equity market seems to have already priced in the worst case scenario. Valuations are attractive and positive surprises could support the asset class on a relative basis;
  • The FX market as a liquid instrument to play trade disputes and political uncertainty.

There is not much room to make mistakes in this sort of market: potential gains and losses show an asymmetric profile. We recommend keeping a cautious risk stance. We think it is key to protect YTD gains (which are not far off our goals of the beginning of the year), as we are well aware of an overall increase in fragilities.

Fixed Income: Expect rates swings on monetary policy uncertainty

Contributing Authors

Eric Brard
Head of Fixed Income, Amundi

Yerlan Syzdykov
    Head of Emerging Markets, 
Amundi

Ken Taubes
    Chief Investment Officer, US, 
Amundi Pioneer

We see two key themes driving fixed income markets: 1. The potential impacts of a trade war on growth prospects and 2. The Fed’s and the ECB future dovish policy stances. The two themes are strictly interconnected as they drive market expectations on CB policy moves, with CB on their side watching out for growth evolution and financial conditions to reassess their policy mixes. The implications appear to be a strong push on yields towards record-low levels, with markets in our view too complacent on future FED cuts and a continuation of a more volatile regime on bond markets. It is paramount to be ready to tactically adjust duration views, play curve opportunities and seek carry with a selective approach to avoid areas of complacency and poor fundamentals or unrewarded liquidity risks.

DM bonds

We expect US Treasury rates to stay supported, due to the increased downside risks to growth and the low visibility on trade issues which, in our view, encourage a prudent approach. We see some value in TIPS. Despite the recent weakness in inflation data, an escalation of tariffs will tend to boost near-term inflation, a concept that is currently completely off investors’ radars: market measures of inflations expectations (eg, inflation breakeven) are at extreme lows.

In Europe, from a relative value perspective, we maintain a positive view on the main peripheral European countries, preferring Spain to Italy based on higher political risk and potential warnings on the budget deficit (though 30Y Italy could be an interesting area to monitor). We see opportunities on the Euro curve (e.g., playing a flattening move on 5-30Y segment).

Credit

Credit is well remunerated on the basis of current outlook, but we recommend a selective approach, with a preference for the short end of the credit curve and favoring Euro IG. In the US, given the increased risks, we continue to recommend a ‘careful carry’ posture that involves reducing overall risk and moving up in quality. Within government-quality sectors, we view Agency MBS as especially attractive relative to nominal Treasuries. We continue to play the strong fundamentals of the consumer sector within the structured securities’ space.

EM bonds 

Despite recent trade tensions, performances for both EM local and external debt were positive, benefiting from a tightening in spreads. Potential FED cuts this year and the lower-for-longer yields in DM should favor EM assets. We like EM local duration (Brazil, Indonesia, Russia and South Africa) as we think that EM rates can perform well in different macro scenarios due to anchored inflation expectations. We are still cautious within EM LC, especially in low-yielding, China-sensitive economies in Asia, but our outlook has tactically improved, given a stable US dollar.

FX

The USD remains one of the highest yielding among the main DM currencies and could offer some protection against trade escalation. We stay cautious on the Euro. On EM, we favor some Eastern European and LATAM currencies (BRL and RBL), while staying cautious on Asian ones (KRW, TWD, SGD) more vulnerable to protectionism.

Equity: Play quality cyclicals, stay away from “bond-proxies”

Contributing Authors

Alexandre Drabowicz
Deputy Head of Equity, Amundi

Yerlan Syzdykov
    Head of Emerging Markets, 
Amundi

Ken Taubes
    Chief Investment Officer, US, 
Amundi Pioneer

Overall assessment

The equity rally was capped early in May on renewed concerns about US tariffs, but after the pullback, the equity market quickly recovered, staying close to all-time highs. What is peculiar regarding this market is that flows have not accompanied the rally of the first months of 2019, and this is especially true for DM equities. In an environment of low rates and a prolonged long cycle, with deteriorated but stabilizing macro fundamentals, we believe that equities could continue to be supported, based on interesting valuations (in some segments), low investor positioning, and potentially supportive factors further extending the cycle (dovish monetary policy and areas of supportive fiscal stance in Europe). Nevertheless, with uncertainty still high, the market will continue to be vulnerable. Volatility and valuation dispersion could offer opportunities for active stock picking.

DM Equities

European markets look more attractive vs the US based on valuations: the Brexit saga, Italian political situation, exposure to trade issues, and low growth have contributed to Europe being unloved. This perception could change with a Brexit deal and with some improvement on the US-China trade front. We don’t foresee earnings growth driving European equities from here into the next year. Earnings growth is probably set to continue to be revised downward, although not equally across sectors and names. This environment plays well for selecting opportunities among and within sectors. Overall, we prefer cyclicals vs more defensive segments, which, in our view, have become too expensive. We like high-quality industrials with strong balance sheets, some of which discount very negative outlooks, and we see opportunities in healthcare as well. We find tactical opportunities selectively within European banks which on the whole are trading at extremely depressed valuations. The negative story on European banks is well known, but implied expectations are too low in some of the higher-quality core European banks.

In the US, the value segment is at the cheapest levels since the tech bubble and the financial crisis. In order to have a strong performance of the value sector, we need reflationary conditions which are not visible in the current phase of the cycle. But the heavy short positioning and the extreme valuations suggest a preference for at least some segments of the value space, in particular: quality cyclicals with long-term growth characteristics, but priced for a recession; retailers relatively insulated from pressure from online sellers; mega cap banks that have been regulated into stability and that have the scale and technology to win. Among our strongest convictions, we believe that “bond proxies” stocks are extremely overvalued (e.g. some consumer staples and utilities stocks). 

EM Equities

At this juncture, we think the US-China trade issue remains the main trigger that could either boost or negatively affect the asset class. Despite a still-constructive outlook for EM equity supported by our expectation for a deal to be finally reached (at least partially) and earnings stabilization, we expect short-term volatility. Therefore, we have turned slightly more defensive on China for the time being. We focus on markets where valuations look set to remain supportive and where idiosyncratic risk is less pronounced, and avoid sectors most exposed to possible tariffs.

Important Information

Unless otherwise stated, all information contained in this document is from Amundi Pioneer Asset Management (“Amundi Pioneer”) and is as of June 17, 2019.

The views expressed regarding market and economic trends are those of the authors and not necessarily Amundi Pioneer, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Amundi Pioneer product. There is no guarantee that market forecasts discussed will be realized or that these trends will continue. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested.
This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any service.

Date of First Use: June 24, 2019.