Increased risk requires a cautious attitude

Wednesday 29 May 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

After weeks of relative stability, the threat of a trade war has returned, shaking investor confidence and awakening markets from complacency. However, while there is still a significant optimism in the market that a deal can be struck, we believe that the risk of disappointment leading to another wave of volatility remains significant.

What we have seen recently is that the politics continue to dominate financial markets, but mainly at the news flow level: political risk is currently perceived as a short-term nuisance, but its impact could have much longer and more significant implications should it interfere with the economic cycle. Even our central macro scenario – i.e., a continuation of moderate global growth, with the growth differential between Emerging and Developed Markets widening in the second part of 2019 and low inflation thanks to accommodative central banks – could be challenged in case of a material escalation of the trade war. In fact, retaliation by China could mean the extension of tariffs to all remaining Chinese exports to the US. This could have a direct impact on GDP (reduced exports) as well as indirect impacts related to business and consumer confidence, with rising inflationary pressures and input costs affecting corporate earnings.

However, we do not think a deal is just around the corner. The risks of a tough and prolonged battle remain and will not fade away in the near future, as they are the reflection of the battle of power between old and new empires in the geopolitical landscape. We are also conscious of the unforeseeable side of protectionism (reduced global trade, potential inflation pressures, etc.), and we don’t see it as being priced into risk assets. We expect the tug of war between softer and harsher tones to continue, resulting in further market volatility.

It is also too early for the Fed to cut: markets went probably too far in pricing in a move and we don’t buy this view at the moment. We think that the movement of downward revision to inflation expectations is now completed and could possibly reverse. This would mean that though the inflationary risk is marginal, volatility should show in inflation data and inflation expectations which should open up a less linear and benign phase in the bond space, especially in the US. 
Market focus will soon shift to growth data (trade, earnings) and in some segments - almost priced for perfection - there is little room for disappointment at current risk premia: another challenge for the US.

On balance, regarding these considerations, we believe it is not yet time to go completely risk off, but that it is time to implement strategies to protect portfolios in case of a deterioration of the situation and to take some profit, where investors have achieved target returns, as the risk / return profile looks now asymmetric (higher risks / lower returns expectation).

Financial conditions are quite easy across the board, with dividend yields appealing compared with bond yields, especially in Europe. The recent market movement has brought global equity markets back closer to fair value, erasing the excess of optimism of Q1. Even if the outlook for earnings is not particularly rosy, with earnings converging across regions in a typical late cycle feature, we don’t see any risk of an earnings recession and see potential for bottom-up approaches throughout the year. However, we believe that the global sweet spot is entering a more fragile phase during which absolute risk should be scaled back whilst relative value opportunities could be exploited in favor of some segments in Europe and Emerging Markets.

This is clearly a tactical view for the remainder of the year, as in 2020 the risks of further deceleration will resurface, but in a low yield world playing tactical opportunities is crucial to adding some oomph to an otherwise lacklustre returns picture.

Fixed Income: Pricing for safety is, and will likely remain, high

Contributing Authors

Eric Brard
Head of Fixed Income, Amundi

Yerlan Syzdykov
    Head of Emerging Markets, 
Amundi

Ken Taubes
    Chief Investment Officer, US, 
Amundi Pioneer

The scenario of moderate growth and dovish central banks remains supportive for fixed income, and in particular for bonds which provide investors with an income - ie corporates and EM bonds. However, as these markets are no longer cheap, it is important to “optimise” the carry opportunities across the board (EM debt hard currency, EU investment grade, US corporates less exposed to trade disputes). We expect US Treasuries to continue to protect portfolios in case of an escalation of trade tensions and other geopolitical risks (resurfacing frictions around the Iran nuclear deal could impact the oil outlook). The price for safety is high, with the 10 Y US treasury yield at 2.4% (10 Y Bund yield in negative territory), but it will likely remain so, as there is strong demand for safe assets and scarce supply. As we expect the US dollar to stay around current levels in the short term, non US-investors could consider gaining exposure to this source of protection and liquidity without a full currency hedging.

DM bonds

Current market conditions don’t justify in our view aggressive duration stances. US treasuries may benefit from uncertainty, due to their “safe haven” status, but the market is quite expensive and it is difficult to see rates going far below the current levels: a 25bps cut for next year is already priced in; we do not expect a cut this year. Inflation expectations are low now and we could see a mild repricing in inflation expectations (due to oil, input prices and wages rising) which could cause a return of volatility to fixed income. In relative terms, we see more value in US Treasuries vs German Bunds. We remain positive on EU peripherals bonds, keeping a flexible approach as the political situation appears quite fragile.

Credit

Considering the current economic conditions, carry represents the primary source of return for fixed income investors; investors should maintain a preference for European credit, due to good fundamentals, even if the room for spread tightening is limited considering the strong performance of the asset class since the start of the year. We believe it is appropriate to adopt a “careful carry” position, that involves selectively reducing spread duration and moving up in quality. We see also selective opportunities in the high yield market, especially after the repricing which followed the recent tariff disputes, as the outlook for default rates remains benign.

EM bonds 

Increased trade and political risk still suggest a cautious stance on the EM debt sphere. The EM macro story is still intact and we keep our positive view on the asset class over the medium-long term. The recent volatility, while suggesting us the need for a more defensive and selective approach for the time being, likewise may create attractive entry points in countries and sectors. We thus look for tactical opportunities in hard currency debt, which continues to be an appealing source of carry and may continue to perform well at this stage. We also view exporting countries favourably: they could potentially benefit from a global shift in the supply chain; conversely, we keep a defensive stance on currencies more exposed to China growth.

FX

We have our positive view on the USD in the short term and cautious stance on the EUR due to downside risks on growth.

Equity: Deep dive in search for value

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 intensification of the trade disputes between the US and China halted the equity bull run. However the correction was limited, the US and the European markets partly recovered from the post-tariffs lows, supported by financial conditions which continue to remain loose, dovish CBs, generally easier fiscal policies and relief from the low expectations on Q1 reporting season. Supporting factors for the market are still in place, but a cautious and selective approach is preferable due to the wide spectrum of geopolitical risks and the less appealing risk/return profile compared to the beginning of the year.

DM Equities

US equity valuations remain attractive relative to fixed income. There are opportunities in quality and growth, but these are very stock- or vertical (i.e., within a sector)-specific. We see value in companies linked to infrastructure/cloud/data centre spending (these stocks sit in three sectors), selective financials such as insurance brokers, and auto & home insurance. In addition to valuations, many of these services stocks have lower foreign input costs that might be subject to tariffs and are also less exposed to potential trade retaliation given they have less non-US sales exposure than goods companies. Services stocks have faster sales and earnings growth, more stable gross margins, and stronger balance sheets. We are now cautious on capital goods, tech hardware, and semiconductors, industries which had been among our preferences in the past few years. Bond proxies, such as consumer staples and utilities, plus staple-like companies with no structural threats in many other sectors, are expensive on a relative-value basis.

European equities could offer interesting entry points after the EU elections, should the economic outlook improve in H2 and domestic demand remain resilient, as we expect. The current features of the market (increasing valuations dispersion, lower sectoral correlation) fit a stock picking approach. We continue to see selective opportunities in the cyclical part of the market (but with less conviction than one month ago), while the defensive part is expensive. Industrial and energy are the high conviction ideas, while on banks we believe a cyclical rebound has to be confirmed to see a convincing repricing opportunity. In the defensive space, health care sector is our favorite choice.

Japanese equities show compelling valuations but a possible strengthening of the yen backed by increased uncertainty represents an headwind for the equity market.

EM Equities

We see a mixed picture for EM equities: relative performance will now largely depend on the development of US-China trade story. A satisfactory deal would be beneficial for EM stocks, as it is not fully priced in at the moment. Given ongoing uncertainty, downside risk are still lurking in the background, suggesting near-term defensive positioning. Global investors are underweight EM, providing a potential technical support to the asset class. Dividend theme is attractive as the dividend per share growth is accelerating in main countries. We maintain our preference for China given the supportive measures related to credit growth rebound and tax cuts. Also some domestic demand growth stories in Asia, more insulated in case of a trade escalation, are attractive as defensive plays.

Important Information

Unless otherwise stated, all information contained in this document is from Amundi Pioneer Asset Management (“Amundi Pioneer”) and is as of May 21, 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 29, 2019.