Navigating the shift from fundamentals to liquidity

14 Mar 2019

Investors face a regime change towards lower investment returns and more financial market volatility, in other words, poorer risk-adjusted returns, as a decade of quantitative easing (QE) and the accompanying generous central bank liquidity ends and the market aberrations caused by QE begin to reverse.

We expect to see a battle for influence in the markets between fundamental data (macroeconomic, corporate, etc.) and market liquidity. Two principal drivers look set to determine the outlook for asset classes:

  • whether the US Federal Reserve is tightening policy – and with it, financial conditions – or opting for a pause
  • whether the economy is still in the middle of the recovery or the end of the up-cycle is near.

Using these parameters, these are our four scenarios for the main asset markets (see Exhibit 1).

 

Exhibit 1: Central bank liquidity vs. economic fundamentals – scenarios

Central bank liquidity vs economic fundamentals

 

Scenarios seen so far

Interestingly, in the last couple of quarters, markets have cycled through three of the four quadrants in this matrix.

In mid-2018, markets were in the top right-hand quadrant – equities rallied and (real, i.e. inflation-adjusted) bond yields rose.

As growth fears increased, but the Fed still tightened policy, markets transitioned to the bottom right-hand corner – equities suffered and (real) bond yields eventually fell.

Markets have now switched to the top left-hand quadrant as the Fed shifted its stance on the course of rates to hold and growth fears stabilised – risk assets such as equities were bid, bond yields moved sideways (and real yields moved down) and breakeven inflation rates rose on reflation hopes.

Emerging market assets are at an interesting juncture given that China has started easing its monetary policy again in a bid to tackle the economic slowdown (and the pressures from the trade war with the US). As an asset class, EM can be expected to do well in view of the shift in the Fed’s stance, removing fears that a tighter Fed policy would draw investor funds away from EM. Range-bound (i.e. broadly stable) bond yields and a broader recovery in risk appetite should also support EM assets.

In many ways, we are reminded of events in 2016 when, after underperforming sharply (with commodities also weakening), emerging markets did well heading into a policy pause by the Fed and as powerful economic support measures by China came through.

 

Staying put as the risk/reward looks unattractive

We are not chasing the latest market moves. On emerging markets, for example, investor flows have been strong so far this year and while developments in the talks on China-US trade relations have been positive, nothing firm has been agreed to date. The tensions could rise gain swiftly, raising fresh clouds over the markets.

Accordingly, we find directional exposure to risky assets unattractive at this point. This is especially true given that stocks continue to sit in the middle between a bullish scenario and a bearish one (see Exhibit 2). We view the macroeconomic downside risks as bigger than the upside potential risks, which also makes equities less attractive.

Returning to Exhibit 1, it is worth noting that only in the top left hand corner of the matrix are equities in a ‘sweet spot’. Elsewhere, their prospects are less rosy. So, we prefer being structurally neutral on equities, but we leave room for tactical trading. In this light, we closed our tactical equity short in February.

 

Exhibit 2: S&P 500 scenarios – halfway between a bull and a bear market

S&P 500 scenarios: halfway between a bull and a bear market

Source: Bloomberg and BNPP AM, as of 28/02/2019

 

In fixed income, we hold a broad underweight in European bonds since we believe that inflation will rise gradually and the ECB will eventually normalise monetary policy. Given the recent gains in Bunds, we now have a further short position in 10-year German bonds. With Bund yields at just 0.10%, we see scope for an eventual bounce in yields. As such, we regard current levels as attractive entry points.

 

Building robust, diversified portfolios

Among our thematic multi-asset positions, we are long the French CAC 40 equity index / short the German DAX. We believe Germany is more exposed than France to any de-globalisation pressures. This trade also aims to reduce our exposure to possible renewed trade tensions between China and the US.

Adding diversification and a defensive tenor to multi-asset portfolios, we are long 5-year US bonds / short 5-year German bonds. Our view is that European fixed income will be more vulnerable to a correction when the ECB eventually begins to withdraw policy accommodation.


The views expressed are those of the investment committee of the MAQS team, as of early March 2019. Other individual portfolio management teams may have different views and may make different investment decisions for different clients.

Please note that this document may contain technical language. For this reason, it is not recommended for readers without professional investment experience.