Investment Talks: Brexit Muddles Through the Approaching Parliamentary Vote
Friday 28 December 2018
Investors are facing an unsettled environment. For 2019 we think it will be key to look at three areas:
1. From economic deceleration to where? It is time to look at where the economy is heading after the synchronized slowdown that the market has now priced in. A global economic recession is not the central scenario. The US economy is still enjoying solid growth and barring a major policy mistake (from the Fed or Trump), it should continue to grow nicely, although at a decelerating rate. Europe’s slowdown is more pronounced, as it is bearing the brunt of multiple political issues (Brexit, Italy and more recently France). However, with some of the risks cooling or passing (easing of trade tensions, weaker oil prices, European elections in May), we see a possible stabilization of economic conditions through the year, with growth expected to slow down but remain above potential in 2019/20. In EMs the picture is more varied, with some countries expected to decelerate (China) and the emergence of some positive stories (e.g., Indonesia). Overall, we still see a benign economic scenario, with trade disputes and geopolitical factors being the main risks to monitor.
2. Fed pausing or continuing rate rises? We do not share the view of some that the Fed will stay on hold from now on, even despite tightening financial conditions, as wage pressures have not disappeared and the Fed’s credibility would be damaged if the market should perceive it as holding back as a result of recent political interference. On the other hand, we believe that the Fed will scale back its ambitions for tightening, as higher rates are already affecting corporate profits and financial conditions are tighter. The Fed’s moves will also have consequences for other central banks (CBs); it will be more difficult for the ECB to raise rates if the Fed suspends its monetary tightening. We don’t see any interest rate normalization in the Eurozone in 2019/20. In EMs, some CBs that moved to a hawkish stance in 2018 could turn more neutral/dovish amid easing inflation conditions and less pressure on their currencies.
3. EMs: perfect storm or a recovery story? EMs have suffered multiple headwinds –higher US rates, the strong USD and idiosyncratic stories. The outlook could stabilize in H1 and improve later on amid a more dovish Fed. Our central scenario sees a soft landing in China as achievable, given the available policy space. Idiosyncratic factors (especially in Latam) and the global trade outlook will be crucial.
All in all we believe that global risk is still asymmetric as the process of repricing growth expectations and the related adjustments of risk premia unfolds, leading to a restoration of value across the board. Still, this restoration of value and the progressive positive alignment of planets (milder path on US rates, peak in the dollar, slower US growth) bodes well for progressive exposure to EMs. Hence, we would recommend starting the year with a cautious approach on risk assets and being ready to play any opportunities that arise from the current repricing. In EMs, we suggest entering in small steps, while in DMs, as the cycle matures, the focus could move towards more quality assets, avoiding overcrowded/over-indebted assets and less-liquid areas of the market. In fixed income, investors should stay neutral on US duration to help mitigate overall market volatility. In credit, the recent spread widening could re-open opportunities but with a selective approach, as tightening financial conditions, refunding needs and the high leverage reached by many companies make this asset class vulnerable. Long-term investors should get back to fundamentals to seek valuable assets in a more volatile world.
* EM = Emerging Markets, DM = Developed Markets, ECB=European Central Bank
Multi-asset: We believe investors should keep limited directional exposure to equity and credit due to weaker growth momentum, geopolitical risks and fragility in investors’ confidence. We maintain a focus on portfolio diversification among regional equities. EMs are attracting our attention as an end to the Fed’s tightening cycle approaches and because valuations are cheap. On the bond side, we suggest exposure to US Treasuries and cautious credit exposure, with the opportunity to increase these in 2019.
Fixed income: We keep a close to neutral stance on duration in the US. We see little value in rates in core Europe. We maintain a cautious approach on credit, as fundamentals remain relatively stable but spreads could remain under pressure due to rising funding needs. We continue to prefer less indebted corporate issuers. On EM bonds, we are becoming more constructive, as the market seems more resilient despite risk assets being under pressure.
Equities: In the US, earnings growth is slowing due to price pressures and economic slowdown. This is a challenge for EU equities too, while we are becoming more constructive on EMs. Globally, our bias remains towards quality companies with strong balance sheets and attractive valuations given the prevailing uncertainty. In Europe “cheap” quality is now more focused on cyclicals compared with defensives, which benefited from a rally over the last three months. We think that investors should look at single stock opportunities rather than at sectors.
After the sharp rise in real yields generated by Fed policy normalization, in the last two months, US Treasuries have rallied amid political concern and economic deceleration. In a rapid move the market switched from discounting 3/4 hikes to discounting less than one interest rate hike for 2019. In this bumpy path for interest rates, corporate and EM bonds suffered strong outflows. Credit spreads have significantly repriced, discounting, in our view, a probability of recession and not just a deceleration. EMs have recently shown some resilience, possibly an early signal of investors’ confidence coming back. The key question for fixed income investors, is how far the Fed can go on hiking rates, amid already tightening financial conditions. We believe we are getting close to the point at which the Fed is turning more neutral, and this would help relax some pressure on the USD and ease liquidity conditions. If our central scenario is confirmed, the Fed is likely to pause next year and there are signs of an easing in trade tensions, so we see the recent cheapening of DM credit and EM debt as an opportunity to rebuild exposure on more attractive valuations – but very gradually and on a selective basis.
The cyclical deceleration of the economies, combined with market uncertainties, tends to exert a downward pressure on the yield curves. We prefer US rates among DMs. In Europe, we keep a neutral stance on peripherals. In Italy, while progress has materialised, we prefer to stay prudent, maintaining a wait-and-see stance, as we expect some risk premium to remain. We see opportunities in break-even inflation, as growth is above potential and the output is quickly closing. On corporate bonds, during the second half of the year spreads priced in the higher rates and the higher corporate leverage, creating attractive entry points on selected issuers. In Europe, new issuance could give opportunities to re-enter the market. However, Euro credit will remain volatile, as political uncertainty is high and European growth is decelerating, with risks tilted to the downside (internal and external risks, considering Europe is quite exposed to the Chinese slowdown). In the US, credit offers moderate value as fundamentals remain relatively stable, but extended credit poses some risks. We suggest to favor more liquid issues in IG and specific segments of the HY market (single-B ratings offer more opportunities of selection).
Sentiment has recently shifted more positive for EMs on the back of a Fed that is less hawkish than expected and a China-US trade easing. The technical backdrop is supportive for both local and external EM debt, but our preference is for hard currency at the moment, as we are confident that the asset class may deliver positive returns over the medium term (the yield on EM external debt is higher than the yield on EM local debt for the first time since 2009) while potentially protecting investors against currency risk. We look more favourably to countries with less political risk (the political agenda is very crowded for EM in 2019), those that are less exposed to trade disputes and also those with higher carry.
The upward pressure on the US Dollar should begin to wane next year. In Europe, we prefer Nordic currencies (SEK, NOK) to the Euro as these are more sheltered from Euro area political stress. The sterling could still suffer from volatility as the tail risk from the political crisis is still open.
After the sell-off in October and the modest rebound in November, markets turned negative again at the beginning of December, as fears on future growth prospects dominated market sentiment. The US is now adding to the list of countries in the correction area, though a further downside without a recession is highly unlikely. A relief rally ahead is possible, with a possible trigger being a more dovish Fed. A Fed pause should also support Emerging Markets, which are already in bear territory. Hence, we are becoming more constructive on EM equity, though we do not think it is time yet to aggressively increase risk allocations as the overall economic and geopolitical outlook remains uncertain. Overall, we remain focused on quality at a reasonable price.
Europe: politics vs. valuations
In Europe, additional uncertainty coming from recent yellow vest protests in France is adding to an already weak sentiment due to Brexit and Italy’s budget issues. Bottom-up analysts’ consensus for earnings seem elevated and revisions are likely to converge lower. European equities are discounting a bigger slowdown in growth, but certainly not a recession. Against this backdrop, we stick to the view that a strong focus on the quality of companies and the sustainability of earnings growth is key, as cost rises add pressure on European earnings. The turnaround in favor of defensives against cyclicals has been brutal – it is difficult to chase this move as valuations in defensives are trading at high levels in relative terms. We continue to see good opportunities at single stock level, but avoid big sector views. Sentiment is almost at an all-time low and the technical unwinding of positions could continue despite valuations in Europe becoming attractive.
US: time to lower the cyclical tilt
With increasing signs of economic and earnings growth deceleration, the big question is whether the cycle is over or flattening. In our view, for industries such as capital goods, banks or semiconductors, the market is waiting to see them execute successfully through a slowdown to then reward them with the positive re-rating that many of them deserve for improved, more stable business models vs prior cycles. With this observation, we have become more cautious on cyclicals, where we maintain a focus on the highest conviction cyclical stocks, those with the most valuation support that are best able to successfully navigate a slowdown. In addition, after the correction in tech, we are leaning towards increasing bias to tech and quality that can withstand late cycle pressures, while, as mentioned already, lowering our cyclical bias.
Emerging markets: improving outlook
The market is starting to price in a gentle deceleration in US growth and less hikes from the Fed – likely to lead to a weak US dollar – therefore making the environment more constructive for EM equities. We expect EMs to deliver a decent improvement in both earnings and valuations, with the valuation picture becoming increasingly attractive regardless of the different scenarios. Within EM equities, we tactically prefer China (we favor the technology and energy sectors) as most of the concerns on trade tensions seem already priced in and the Chinese policy stimulus could be enough to prevent a further slowdown in growth. Russia is attractive, in our view, thanks to the historical cheapness of equities, but it is vital to monitor the impact of sanctions. For the time being, we prefer to stay out of countries with high political risk (namely, Turkey and Argentina).
Group Chief Investment Officer, Amundi
Deputy Chief Investment Officer, Amundi
Head of Fixed Income, Amundi
Head of Emerging Markets, Amundi
Kenneth J. Taubes
CIO of US Investment Management, Amundi Pioneer
Deputy Head of Equity, Amundi
Diversification does not guarantee a profit or protect against a loss.
Unless otherwise stated, all information contained in this document is from Amundi Pioneer Asset Management (“Amundi Pioneer”) and is as of December 28, 2018.
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: December 28, 2018.
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