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Tuesday 14 January 2020
Investment Talks, Perspectives
2019 proved a strong year for US assets, with US equity markets recording the strongest annual total return since 2013 and the US aggregate bond index up almost 9.0%. In addition, the past decade proved the best ever for the S&P 500 index, which returned 256% overall, well above its historical average. It was also the decade when US equities dominated other markets, with an outperformance of more than 90% versus the MSCI World index.
Despite such highs, we believe that US assets still offer compelling opportunities for global investors in 2020, though these are dependent on the evolution of three themes:
Our key convictions on US assets for 2020 are as follows:
Following the three rate cuts agreed by the Fed last year, the bar for delivering further accommodation is high, and the central bank may be willing to allow some inflation overshooting (unlikely) before hiking rates. The renewed expansion of the Fed’s balance sheet will keep financial conditions loose – even if it cannot be seen as a new round of QE – and will limit the upside pressure on rates. Politics will remain center stage, with Trump’s impeachment trial and the electoral campaign set to get under way later this year. The political attack on the Fed’s independence should continue, with pressure on the central bank to cut rates further and weaken the dollar. The 10-year US treasury yield is likely to trade in a wide range and remain dependent on macroeconomic and political risks. Overall, we foresee limited upside on US yields, with potential opportunities in a trading range and neutral duration positioning, with a focus on steepening.
In 2020 US credit markets will remain supported by benign macroeconomic trends and technical factors. On the former, the US economy is expected to grow more slowly this year but stay supportive for markets at – or slightly above – potential GDP growth. Regarding technical factors, neutral bank lending standards are supportive, together with low equity-implied volatility driving both HY and IG risk premiums. In addition, distress ratios – the share of HY bonds trading at spreads larger than 1,000 bp over government bonds – remain nonthreatening.
However, micro fundamentals are not as healthy. Valuations are tight and getting even tighter due to the search for income in a low-yield environment for global fi xed income, coupled with a strong increase in outstanding corporate debt over the past decade. Outstanding US IG corporate debt has increased from an estimated 2.3 trillion USD in 2007 to 7.3 trillion USD currently, and most of this expansion has occurred in the BBB-rated segment, which currently accounts for about 50% of the US IG market. Valuations appear too high versus leverage metrics, especially among lower-rated IG issuers. While this may not be a big deal in the short term, it is a risk for market trends in the longer run.
Over the course of 2019, spreads decoupled from macroeconomic leading indicators, failing to incorporate the higher risk premium consistent with the fall in confidence indicators. The most recent stabilization of the Manufacturing ISM index, together with the positive news fl ow on global trade developments, bodes well for a reduction of this valuation gap. Such a reduction is likely to be driven by the bottoming out of leading indicators rather than by a widening in credit spreads.
Despite the dramatic rise in outstanding US IG debt, US corporates are cautious in managing their financial leverage, especially BBB-rated firms, to avoid being downgraded into the HY universe and to keep the cost of funding under control.
In the HY universe, the recent decoupling between euro and US HY spreads has proved to be mostly an energy story. If this sector is excluded, US HY trends stabilized last year, in line with trends in the European HY market, while the energy sector showed signs of distress. Of the 64 defaults recorded globally over the first nine months of 2019, 19 – or 30% of the total – were in the energy sector, according to the latest Moody’s report on defaults. The energy sector’s share of defaults was 19% over the same period of 2018. The key reason for the deterioration was the plunge in oil prices at the end of 2018, which weighed on both the default rate and the distress ratio of the sector.
The combination of supportive macro fundamental trends and tight valuations calls for high selectivity in credit markets. Fixed income investors should seek opportunities across multiple sectors, with a focus on diversification and liquidity. Investing in securitized credit sectors, including asset-backed securities, commercial mortgage-backed securities (ABS) and residential mortgage-backed securities (RMBS), is consistent with this approach. These sectors are attractive when considering their relative valuations, strong credit protection, US consumer focus and lower exposure to global growth risks. Agency mortgage-backed securities are attractive relative to US Treasuries after the recent spread widening.
Securitized assets offer search-for-yield opportunities in 2020. They are financial instruments where cash flows are derived from and secured by specific underlying collateral. In a securitization, assets are sold into a trust, which then issues securities backed by those assets. Securitizations include bonds backed by residential mortgages, commercial mortgages, automobile loans, credit cards, bank loans made to corporations and other assets. By assigning different payment priorities to each bond within a securitization, investors can access a menu of risk and return options in terms of both interest rate risk and credit risk. The most common securitization is the mortgage-backed security (MBS), where residential loans serve as the collateral. Within the MBS market, the largest sector is agency MBS, with these akin to the covered bonds issued by the government-sponsored enterprises Fannie Mae, Freddie Mac and Ginnie Mae. Agency MBS differs from private-sector securitizations because they o er an explicit or implicit guarantee from the US government. In contrast, individual investors are responsible for the credit risk embedded in the higher-yielding segment of residential, commercial, consumer and other securitized credit.
Securitized assets were at the epicenter of the 2008 global financial crisis. Thanks to stronger consumer balance sheets and the market reforms that have taken place since then, it is unlikely that securitized assets will cause the next crisis. The backward-looking bias often embraced by investors explains the current disconnect between risk premiums and fundamental risk. Today, US household debt service costs are at their lowest levels since 1980 and the US savings rate is above its long-term average. Amid a weakened global growth environment, the US consumer has remained resilient. For this reason, fixed income investors can benefit from investments in securitized credit sectors that are supported by the financial health of the US consumer. Yields in the agency MBS market offer an attractive entry point versus Treasuries. While agency MBS have little to no credit risk because of the explicit or implicit guarantee from the US government, the expected returns on these securities are higher than comparable duration US Treasuries due to the prepayment option of the underlying borrowers. Investors are compensated for taking this prepayment risk. With the recent decline in interest rates, investors are overpricing the risk of these prepayments, and spreads appear dislocated compared with IG corporate bonds. Refinancing rates between different agency MBS sectors have diverged due to technological and systemic enhancements in the mortgage origination industry, but careful security selection can mitigate these risks and potentially lead to excess returns. Securitizations are believed to be illiquid but agency MBS and high-quality ABS offer investors liquidity second only to US Treasuries, while higher-yielding securitized assets can exhibit lower liquidity than comparably rated corporate credit, due to their smaller issuance size and lower transaction volumes. Like any investment strategy, it is critical to price this risk and match the liquidity of the assets with the liquidity of the investment vehicle and the investment goal.
The US equity market is entering 2020 in the longest bull run in history, though not the strongest. In terms of cumulative total return, the current bull market ranks second only to the expansionary cycle that started in 1990.
To assess if such a trend will continue this year, monitoring the developments of the Manufacturing ISM index will be crucial. We should bear in mind that in a scenario of slow consumption and inflation, low official rates and low bond yields, the Manufacturing ISM and equity markets show high correlation. The Fed delivered three rate cuts in 2019. Since monetary policy operates with lags on the real economy, the Manufacturing ISM index could bottom out over the next few months, allowing the US bull market to run throughout 2020. The favorable geopolitical landscape – should it be confirmed as in our main scenario – will provide a window of opportunity, at least until the electoral campaign for the upcoming presidential election officially gets underway.
At 10% YoY, the 2020 IBES forecast for US earnings growth is somewhat optimistic, in our view. Over the past 10 years, such consensus has been constantly downgraded as the year progresses and this year should be no exception. We expect US earnings growth to be mid- to high-single digit, aided by a recovery in manufacturing activity. Earnings growth will also be helped by easy comparisons in some cyclical sectors, such as energy and materials, where earnings were depressed in 2019.
P/E ratios are reasonable when factoring in the low interest rate environment and should support equities further early in the year. Later on, an acceleration in EPS growth should cause equities to move higher. EPS growth will benefit from share buybacks, which we estimate will contribute 2% to overall EPS growth in 2020.
Finally, investors should monitor the upcoming run-up to the 2020 presidential election. Since World War II the US equity market performance has been shaped primarily by the business cycle momentum and secondly by economic policies pursued under different presidents, as different policies may cause sector/single stock rotation.
Our main scenario is exposed to a few low probability risks, including:
Unless otherwise stated, all information contained in this document is from Amundi Pioneer Asset Management (“Amundi Pioneer”) and is as of January 10, 2020
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: January 14, 2020
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