Between growth fears and policy support

12 Feb 2019

  • It’s all about growth – risky assets rebounded strongly in January after a sharp re-pricing of economic growth assumptions late in 2018
  • A lot of bad news priced in? – with consensus EPS forecasts cut sharply, the bar was low for a bounce
  • Central banks to the rescue? – the Federal Reserve has thrown markets a lifeline, but hopes of indefinite central bank support look misplaced
  • Earnings delivery will be key – we see limited scope for multiple expansion in the medium term
  • Downside risks linger – key issues such as quantitative tightening and China-US trade tensions are far from resolved.

The sharp sell-offs in risky assets during the last quarter of 2018 did not take place in a vacuum – growth was weakening considerably. At the same time, consensus EPS growth forecasts were downgraded aggressively – notably across all regions. Yet a peak-to-trough fall of 20% in the S&P 500 index looks excessive to us. While incoming macroeconomic data clearly warranted lower equity returns, we believe far less of an adjustment was justified than the recent setback in equities (see Exhibit 1). Put differently, the bar for earnings per share (EPS) surprises is quite low in the current earnings season.


Exhibit 1: A lot of bad news in the price: equity returns based on aggregate macroeconomic data


Source: Bloomberg and BNP Paribas Asset Management, as of 31/01/2019


Central banks to the rescue?

After central banks – and their exceptional monetary policies – underpinned markets for many years, investors now face quantitative tightening (QT). The removal of quantitative easing should lead to higher market volatility, but in the short term, there are two key (dovish) developments. These have helped fuel the rebound in risky assets since early January.

  1. The US Federal Reserve has clearly signalled a pause in its tightening cycle. It is no longer on a pre-determined monetary tightening path.
  2. Policymakers in China have recently provided more stimulus again, to fuel economic growth, helping put in a floor under emerging market equities.

 However, in the medium term, we believe that hopes for continued central bank support of the asset markets are misplaced. Indeed, we still foresee policy tightening.


Earnings delivery will be key

In a QT world, the market drivers – and with it, the focus of investors – will change. With central banks removing policy accommodation, corporate re-leveraging running out of steam and eventually possibly even higher inflation to boot, we are unlikely to see significant multiple expansion in the medium term. In such an environment, earnings will have to do the heavy lifting.

All eyes are thus on the current earnings season. With some 25% of the S&P 500 companies having reported, we have seen positive surprises. But compared to history, these are relatively small, which is disappointing in the context of the recent sharp fall in earnings expectations. This does not leave us extremely optimistic.


Downside risks linger

Our view is that the balance of risks around our base case scenario is to the downside, not least because key issues such as quantitative tightening and China-US trade tensions are far from resolved. Due to the changing backdrop – and as explained in our recent publications – our approach is ever more tactical. In this light, we recently shorted equities into the bounce (see Exhibit 2) since we believe markets rallied quite quickly on only a few positive headlines. Structurally, we are less convinced as to where markets go from current levels.


Exhibit 2: Time for a tactical short in US equities


Source: Bloomberg and BNP Paribas Asset Management, as of 31/01/2019


More volatility on the horizon as imbalances unwind

The market imbalances of recent years, including persistently low asset price volatility, high risk-adjusted returns and historically tight risk premia, look set to be unwound as central banks eventually tighten policy. Since the structural direction of equities is now unclear, we prefer to be neutral in the medium to long term. But our stance remains tactical, and in this light, we recently took a short position on US and EU equities.

We are long the French CAC 40 versus the DAX since we view Germany as more exposed than France to de-globalisation.

We are structurally underweight in fixed income: we foresee gradually rising inflation and further monetary policy normalisation. We are long five-year US bonds versus German Bunds since we believe European fixed income is more vulnerable to a correction as the ECB begins to withdraw policy accommodation. Being long US Treasuries should be a good defensive position in risk-off markets.

To limit our exposure to renewed trade tensions between China and the US, we are long USD versus a basket of Asian currencies. We have a tactical short in the Canadian dollar versus the Norwegian krone given their current valuations and the outlook for central bank policies.

Asset allocation overview