Asset allocation outlook – selectively long equities and short fixed income

25 Sep 2018

The global macroeconomic environment is becoming more challenging. Global GDP growth is slowing, downside risks to growth are becoming clearer and a synchronised bounce is becoming less likely.

One of the biggest surprises in financial markets so far this year has been the divergence in equity performance across regions. At the beginning of the year, most investors expected robust global growth supported by a synchronised recovery. As it turned out, global growth slowed somewhat, but the most salient feature was regional divergence.

This divergence in economic performance has translated into a rather unusual dispersion in equity returns since the beginning of the year (Figure 1). So what changed and why was the consensus surprised? We can largely explain these outcomes with three themes: US economic dominance; renewed stress in emerging markets (EM); and economic and political pressure in the eurozone.

Figure 1 – US equities have outperformed emerging market and eurozone equities

cross-asset-returns

Source: Bloomberg, BNP Paribas Asset Management, as at 13/09/2018

 

US economic dominance – fiscal expansion fuels equities and the dollar

The US economy continues to grow strongly, supported by expansionary fiscal policy and cautious policy tightening by the Federal Reserve (Fed). This contrasts with weaker economic growth in other major regions like the eurozone and various emerging markets, notably China (Figure 2). As a result, US equities continued to outperform equity markets in these regions. Another related development was the strength of the US dollar. The combination of tighter monetary policy by the Fed and fiscal expansion supported the dollar against most currencies.

Figure 2: Divergent economic performance across major economies

activity-survey-data-diverge

Source: Bloomberg, BNP Paribas Asset Management, as at 13/09/2018

 

A perfect storm for emerging markets

Another salient development over the past few months has been renewed stress in emerging markets, due to a number of factors.

First, a stronger US dollar and higher US interest rates typically hurt EM assets because they become relatively less attractive, but also due to the fact that many of them have material US dollar-denominated liabilities.

Second, the Chinese economy has started showing signs of slower growth. Third, concerns about trade tensions between the US and China and the likely disruption of supply-chains have soured emerging markets’ prospects.

Finally, some vulnerable economies like those of Turkey and Argentina have faced renewed pressure, raising questions about the health of other EM economies. All of these factors have contributed to the lacklustre performance of EM assets over the past few months.

 

Eurozone under pressure – weaker growth and Italian politics weigh on risky assets

A third theme that financial markets have had to grapple with in recent months has been the underperformance of risky assets in the eurozone, which resulted from numerous adverse shocks. First, economic growth slowed from a strong 2.7% year-on-year (YoY) at the end of last year to a softer, but still solid, 2.1%. Second, Italian political turmoil escalated when the newly formed coalition government sent out an anti-Europe message (which was later toned down) and announced an ambitious fiscal expansion programme that threatens to far exceed the European Union’s rules on fiscal deficits. As a result, Italian assets came under pressure and they remain unsettled due to the lingering uncertainty around the size of the fiscal deficit that the coalition leaders appear set to propose in the forthcoming budget.

 

Looking ahead: selectively long equities and short fixed income

The global macroeconomic environment is becoming more challenging. Global GDP growth is slowing somewhat, downside risks to growth are becoming more evident and a synchronised bounce is becoming less likely.

In our central scenario, US growth is still likely to outperform but we see little room for a meaningful catch-up from other major economies over the next 12 months. While inflation remains contained, it is gradually rising, notably in the US where the core Personal Consumption Expenditure (PCE) index is already at the Fed’s 2% inflation target. As a result, the Fed is set to continue to tighten monetary policy gradually.

In Europe, we expect the ECB to start normalising monetary policy even if the first interest rate increase is unlikely to be before mid-2019. In this context, risky assets are still likely to do well, especially in the eurozone where financial conditions remain very loose. But the global liquidity tide is unlikely to lift all boats; if anything, it will probably be less supportive, especially for assets that have benefited from it, such as high-yield credit. Our dynamic technical analysis is also sending us some cautionary signals on various risky assets, notably EM equities.

 

Remaining long eurozone equities, short eurozone government bonds

Our long-held view of being long equities and underweight fixed income remains in place. We continue to favour long equity exposure in the eurozone, where earnings growth expectations are still low relative to the economic cycle and where gradually rising inflation should restore corporate profit margins. In addition, equity prices already incorporate negative news such as slower growth, Italian politics, protectionism and potential bank losses due to exposures to Turkey.

In fixed income, we prefer to express our bearish view by being short eurozone government bonds. Economic slack in the bloc is falling gradually and the ECB should gradually normalise monetary policy. Given how low interest rates are in core markets like Germany, we believe it makes sense to stay underweight as they look asymmetric to the upside.

 

Protection against global shocks

There are various risks to our base case scenario of robust global growth and gradually rising inflation. The main downside risks could be: (i) higher-than-expected inflation in the US and tighter monetary policy by the Fed; (ii) a synchronised global slowdown; and (iii) an escalation of trade tensions and de-globalisation due to increased tension between the US and China.

Given these risks, we believe it appropriate to secure some defensive exposures in multi-asset portfolios with long risk exposure. Being short high yield (HY) credit, for example, makes sense. High-yield spreads are very tight on an historical basis and have benefited from unconventional monetary policy that is now being unwound. We are in a late cycle environment where HY credit underperforms as corporates take on more debt, while equities usually continue to outperform. Our view is that it also makes sense to consider a  long US dollar exposure vs. the euro as a hedge against these adverse global shocks.

 

A thinner US equity rally: mind the US IT sector

Strong growth in the US economy has supported the US equity rally. But there is more to the rally than economic performance. Since 2016, the US equity rally has been largely driven by the US IT sector (Figure 3). The sector’s long-term fundamentals rely on innovation, IT and business models that have the characteristics of monopolies. However, there are short-term developments that make us more cautious about the sector. These include expensive valuations, question marks over the sustainability of the sector’s earnings strength, and regulatory risks – both domestic and from abroad. Our dynamic technical analysis also suggests that the sector is vulnerable to a correction.

Figure 3: US IT sector has led the equity rally since 2016

us-it-vs-us-msci

Source: Bloomberg, BNP Paribas Asset Management, as at 31/08/2018

 

EM value, but no circuit breakers in sight

EM assets have been hit by four developments over the past few months (Figure 4). First, the Chinese economy has slowed by more than markets had expected and China’s policy response has not been overwhelming. Second, Sino-US trade tensions have escalated and the latest round of discussions saw no progress made. Third, the US dollar has appreciated across the board, boosted by the Fed’s policy tightening and US fiscal expansion. Finally, concerns about external and fiscal fundamentals in some vulnerable EM economies like those in Turkey and Argentina have led to some contagion to the rest of the asset class.

Figure 4: EM assets suffered again in August

em-asset-total-returns

Source: Bloomberg, BNP Paribas Asset Management, as at 31/08/2018

We believe there is value in emerging market assets, but it is difficult to assess the timing of any bounce because the potential circuit-breakers are still absent: a weaker US dollar, aggressive China stimulus and fresh Sino-US trade talks. These factors may emerge in the next few months and EM assets could then recover. However, the longer-term prospects are less clear-cut as challenging Sino-US relations and tighter global liquidity look set to remain a headwind for some time yet.