High Yield Market Outlook: July 2020
As the market has less near-term clarity than it did pre-crisis, we believe it is not yet time to take on more risk.
Tuesday 28 May 2019
Perspectives, Investment Talks
The results are broadly in line with what opinion polls had indicated, although with a slight “pro-institution” surprise. Key takeaways are, first, a decline in the votes for the two large political groups which are the social-democrats and the Christian-democrats or moderate right; these two parties had, since 1979, commanded a combined majority in the European Parliament, and this is now over. Second, a rise in other so-called “mainstream” forces, the pro-market liberal center, including the Party of French President Macron, and, even more notably, the Greens. Together, all these pro-institution, pro-European forces command roughly 67% of MP vs. 70% before the elections. Then the other major take-away is that far-right (or right-wing Eurosceptic) parties see their share increasing from roughly 20% to 25%, with prominent cases being France, where the far-right national front comes first before the President’s party, and Italy. However, far-right parties also scored a bit short of expectations in other key countries such as Germany and the Netherlands, while far-left party have seen their share diminish from 10% to 7%.
All in all, while combined radical parties, Eurosceptic parties see their total share increasing from 30% to 32%, this is not the tsunami that could really have been a shock to institutions.
The two historic mainstream parties which can build a majority through a coalition either with the liberal center, or with the Greens will find it a bit more difficult than it used to be, yet it should still be manageable. Radical parties will have a bit more power, especially through parliamentary committees, they could try to propose amendments but they should not be able to block key legislation except on topics where mainstream forces could be very divided.
What is also remarkable is the rise in the participation rate at the vote. Turnouts at the European election had been historically low and falling and this time it rose from 43% to around 50%, which shows a rising interest in European affairs.
The UK is in the midst of a deep political crisis. Conservatives and Labour were sanctioned by voters. Nigel Farage's Brexit party is the big winner. Consequently, Boris Johnson has the wind in his sails to succeed Theresa May. But nothing is done yet. Theresa May's resignation will be effective on 7 June. From 10 June, the procedure to find a successor will begin. Theresa May will remain in office until the end of the procedure. There is no shortage of candidates. We should be fixed by the end of July at the latest. It should be noted that staunchly pro-Bremain parties (such as the Liberal Democrats) also scored well in the election, making the political situation even more polarised and, possibly, bringing more impulse to those demanding a second referendum. It should be remembered that the 27 EU countries must be unanimous on 31 October for a further extension of the deadline, which is not a foregone conclusion. Against this backdrop, the likelihood of the UK leaving the EU without an agreement has increased and it is therefore necessary to continue to prepare for it both at national and company level.
However at the end of the day, everything remains possible: no-deal Brexit, new elections, new referendum, new Article 50 extension, not to mention that it cannot be ruled out that the British Government could simply revoke Article 50. The only good news is that fewer and fewer protesting/populist parties in Europe are calling for the exit of the euro (which would require an exit from the EU). It is likely that they are being vaccinated by the British turmoil.
The economy has been improving a lot since 2013. Despite major disappointments in 2018, above-forecast Q1 2019 figures showed that fears of a general recession were probably exaggerated, especially in Germany, and that, while the manufacturing sector is under stress, it has not, so far, contaminated the rest of the economy. Internal demand remains robust.
Nonetheless, Europe remains vulnerable for three reasons:
Europeans must thus find a way to overcome their differences to strengthen Europe (security and common defense, economic and financial architecture of the Eurozone). Regarding trade, they will have to find a way to speak with one voice.
Many economists point to the incomplete nature of the Eurozone and the need for a common budget. A budget which, in the event of a serious shock affecting one or more Member States, could help stabilize their economies. Such a budget, fueled by national contributions, would make it possible to support the activity when a country is facing a crisis, either alone or with the rest of the Eurozone, limiting the use of painful reforms. This would involve financial transfers to economies in need, unlike the European Stability Mechanism (ESM), created during the crisis to offer loans to states in crisis in return for structural reform plans. This budget of the Eurozone, if it is solely devoted to stabilization, would not need to be very large. Small-scale fluctuations would still be borne by national economies. Finally, access to this fund could be conditional on compliance with budgetary rules (in order to avoid moral hazard).
It may be regretted but it is becoming increasingly clear that a stabilization budget is not ready to come into being in the Eurozone. We must therefore strive to improve market mechanisms. The broadest consensus is about the Capital Markets Union. Europeans need to promote discipline and risk sharing. This would make it possible to better manage the abundant savings of the Eurozone (excess savings on investment amounts to € 340 bn in 2018) towards concrete investment needs such as energy transition, digital innovation or the development of Small and Medium Enterprises. And it would also facilitate macroeconomic adjustment in the Eurozone. Indeed, integrated capital markets can cushion asymmetric shocks in a currency Union. When the shareholding of a company is highly diversified geographically, the profits and losses are also widely distributed. In the United States, for instance, it is estimated that, thanks to capital markets, almost half of the impact of an economic shock is spread among the different states - more than by budget transfers. While in the Eurozone, only 10% of an economic shock is cushioned by private risk sharing.
The EU elections took place in a context of moderate economic growth. Easier fiscal policies are already in place overall. These calls for more fiscal stimulus reflect the sentiment that Europe needs further support at a moment when monetary policy tools are more limited. Easier fiscal policies translate into deeper fiscal deficit and deteriorating debt to GDP ratios, which is not favorable to bond markets in the long run. Shorter term, the implication for the fixed income markets may be quite different across the zone, depending on the situation of the different countries. Germany has obviously way more room for maneuver than Italy for instance, and the more indebted countries are exposed to tensions on their interest rates. A continuing trend could bolster inflation expectations, but would also mean additional fragmentation across the zone.
In such fragmentation the fixed income space offers many opportunities of selection; on peripheral bonds, we prefer Spain and Portugal to Italy. In credit, for example we are positive on industrials but not so on cyclicals and we are cautious on the German auto sector; we see value in financials, and in particular banks, but we are prudent on Italian banks.
We have adopted a moderately cautious stance on Italian debt which is going to navigate between potentially stronger fiscal measures, deeper deficits in a context of slow (negative in the second half of last year) GDP growth, with the risk of being put under an excessive deficit procedure by the European Commission. This could put BTP spreads under pressure and add volatility, not to mention the potential reaction of rating agencies and the additional damage on Italian banks. Even though we do not consider this a major threat over the short term, because Italy and the EU could find an agreement on a more flexible fiscal stance, we prefer to adopt a wait and see stance.
The market reaction on the euro currency has been very limited as the results were largely in line with expectations and they are not a game changer. The key questions at stake will remain the profile of economic growth, the development in the European political landscape after the election in each country, the need for more stimulus and the impact of the various threats that are still at work, whether tariffs or the Brexit. The current environment does not call for a sudden recovery in the Euro currency.
Yes, just having the elections done should remove one uncertainty even if the full implication of the new European parliament will still need to play out: the new Commission as well as the new President of the ECB are still to be elected and those will be crucial steps in determining the path of the European Union over the coming years. Our view is that Brexit and US/China trade relations pose an even bigger risk to sentiment around Europe – these are two uncertainties still not resolved.
We believe there are still good opportunities in the more cyclical compartments of European equities. In particular, domestically exposed names should see the benefit of a stabilization in economic indicators and a potential pick up in H2. In addition, we see some selected opportunities within healthcare and telecoms among the more defensive compartments. Clearly the European economy is very exposed to global trade so it will be impacted by the developments in US/China trade relations.
In the medium to long term there are some challenges in society which will require a corporate response. For the third year running, extreme weather driven by climate change has taken the top spot in the Global Risks Report presented in Davos – and in 2019 the second and third place have been taken by failed climate-change mitigation and natural disasters, respectively. The scale of the challenge is massive and the solution will need to be multidimensional. The very good results of the Greens in the elections, is a clear sign that these themes are gaining traction among the population of many countries. The awareness of European companies to the climate challenge is increasing, and many companies have taken significant steps to address the issue. This is an area in which we have high convictions going forward.
ESG is in our view a structural trend which is gaining traction among corporates and investors. European companies have a good ESG record from a relative perspective, but have further to go. Growing evidence suggests that companies improving ESG fundamentals tend to outperform the market. We believe that this will continue to be an area of focus and opportunities for investors in the years to come.
Unless otherwise stated, all information contained in this document is from Amundi Pioneer Asset Management (“Amundi Pioneer”) and is as of May 27, 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: May 28, 2019.
As the market has less near-term clarity than it did pre-crisis, we believe it is not yet time to take on more risk.
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