27 JUN

2019

Asset Allocation , Emile Gagna , Macro , Nadège Dufossé , Outlook H2 2019

Candriam presents its economic and financial outlook

We are all looking forward to summer sun and summer fun! A privileged moment to take a break, and take time with family and friends.

The economy, President Trump's tweets and the markets, on the other hand, do not stop. Is summer looking good for investors? How to position your portfolio? We offer some elements to ponder with a few words from Emile Gagna, Economist and Nadège Dufossé, CFA, Head of Asset Allocation.

 

Global economy: struggling with uncertainty

At the beginning of summer, the global economy is still plagued by uncertainties. The stock markets may be in better shape than in late 2018, but in most countries manufacturing activity remains sluggish with inventories staying high. Above all, geopolitical tensions are far from abating. Iran has threatened to block the Strait of Hormuz if US sanctions prevent it from exporting its oil, and the conflict with China has little chance of ending soon: Beijing and Washington are fighting for world leadership, especially in the field of cutting-edge technologies. Even if a trade deal were to be signed at the end of June, relations between China and the US would remain a source of uncertainty.

We are heading into a more uncertain phase of the economic cycle, fraught with many political risks and unpredictable communication effects: what does this uncertain economic environment mean for investors? Candriam presents its asset allocation for the second half of 2019.


 

Global economy: uncertainty on the rise 

Uncertainties over global growth are not even close to dissipating as we officially head into summer 2019. The markets have certainly gotten some wind back in their sails since the end of 2018, but everywhere you look industrial activity is still anaemic and inventories are high. What’s more, geopolitical tensions are still going strong with the threat of Iran blocking the Strait of Hormuz in response to US sanctions now hanging over our heads. More importantly, the multilateral order in place since the end of World War II has been challenged, upsetting the balance of power and jeopardising the trust and cooperation which have prevailed until now in trade relations. The threat of customs tariffs on Mexican products may not have been executed at this point, but there’s no guarantee that the deployment of Mexico’s national guard at the country’s southern border will be enough to permanently ease tensions. A quick solution to the conflict with China is unlikely to emerge. It goes way beyond a question of commercial stakes: Beijing and Washington are currently duking it out for world leadership, especially in the field of new technologies. Even if they do strike a deal at the end of June, US-China relations will continue to be a source of uncertainty.

 

China: running out of options... 

China has taken measures to counter the impacts of the trade war, but its options are increasingly limited: take-up rates for urban households are close to saturation for most durable goods, residential investment already makes up a surprisingly high percentage of GDP, and corporations have seen their debt burden grow significantly heavier since 2008. By focusing its measures on rural household consumption and loans to SMEs (which are still struggling to borrow), China is doing its best to work with what it’s got. These measures, which also include a rise in infrastructure spending, are putting public debt on an unsustainable path over the medium term.

 

United States: a soft landing on the horizon?

Growth is still going strong in the US, at least for now. GDP was up more than 3% yoy in the first quarter, partially reflecting the rapid accumulation of inventories, but consumption posted persistently robust growth and consumer sentiment was high. 

Having said that, the preliminary effects of past monetary tightening moves – and perhaps the trade war as well – are starting to emerge: residential investment has slowed sharply in the last year and business investment is starting to lose steam.

With inflation running low and trade war uncertainty taking its toll on economic activity, the Fed has adopted a dovish tone since January, pressing pause on its tightening measures: by giving itself time to observe economic developments, it is clearly learning from the past tightening cycles that often followed on the heels of recessions. If uncertainty continues to adversely impact economic activity, the Fed has clearly stated it will not hesitate to relax its monetary policy as a precaution, with the goal of bringing the US economy in for a soft landing of around 2% potential growth. 

 

Euro zone: weak growth

Meanwhile, the euro zone is having a tough time of it. Q1 growth may have been better than expected, but industrial output is still moving at a snail’s pace. The German economy in particular was hurt by the entry into force of the new WLTP automotive standard, nor has it been spared by global trade tensions. The resilience of business investment, the (slow) improvement in consumer sentiment and fiscal stimulus measures implemented in major euro zone countries should, however, give at least a minor boost to domestic demand in the coming months and secure growth of 1.3% in 2019. 

The euro zone is still vulnerable, though. The threat of higher tariffs on auto imports is very real and would put a dent on Germany’s already weak growth. In France and Italy, poor job creation in “intermediate-revenue” professions is driving up social tensions and populist sentiment. At a time when nationalist temptations are jeopardising unity in Europe, the euro zone has little room to manoeuvre (which its President has just announced he is ready to use). This margin is very real on the budget front, however. Germany especially needs considerable infrastructure investment and has the resources to do so: with a zero-to-negative 10-year interest rate, the government could have a deficit of 2% of GDP – instead of a 1.5% surplus! – without increasing debt/GDP, which dipped back under the 60-pt threshold this year. Italy is another story, however, given its restrictive budget constraints. The government is engaged in a dangerous policy when it comes to sustaining its debt, while continuing to butt heads with the EU authorities. With the ECB’s governance set to change, developments like these are generating additional uncertainty.

 

Our asset allocation for H2 2019

We are taking a more cautious stance in terms of economic forecasts here at the end of H1 2019, with the threat of new customs tariffs by the US sparking major uncertainty for the coming months.

 

What’s the right exposure to equities in the wake of the H1 rebound?

 

The equity markets made a strong comeback from their low point of end-December 2018, although the gap between the performance of the US market (a gain of more than 20%) and emerging markets (a gain of less than 10%) is still considerable. Investors took advantage of the equity market rally to reduce their positions (equity flows are negative overall) and their confidence has ebbed to a low point. The latest survey of global portfolio managers, conducted mid-June , underscored a lot of pessimism: high levels of cash in portfolios, a steep drop in equity buckets and a strong downturn in growth forecasts. This caution can easily be attributed to the persistent weakness of economic indicators, the unpredictability of statements issued by the US president (now negative, now positive), and the unease sparked by the central banks in their QE race.

So should we just give in to this omnipresent pessimism? We don’t think so and have decided to maintain an overweight stance on equities in 2H. We’ll have to relent if the economic slowdown gets worse and the central banks prove unable to curb the ongoing slowdown in activity (potentially exacerbated by excessive trade tensions).

We don’t see a recession in 2020 as the most likely scenario, and after the spectacular decline in yields seen in May 2019, the quest for yield has become a challenge again for investors. The equity risk premium has shot up since last year, due to the drop in equity valuations and yields. As we see it, this is a great time to capture this equity risk premium in our diversified funds.

 

 

The geographic allocation is trickier in the current environment. We are continuing to focus on US equities. The US is leading the pack, and the US market is protected by a double put option: one for the US Federal Reserve and the other for the US president. The Fed is pulling out all the stops to curb the economic slowdown and maintain accommodative financial conditions. It currently has more leeway to relax its monetary policy than other central banks. Meanwhile, the US president has officially launched his campaign for a second term and should logically try to avoid triggering a recession and a slump in the US equities market. From a fundamental standpoint, US growth is more solid, as reflected in corporate profit improvement, and the valuation of US equities is not excessive.

For now, we have reduced our allocation to emerging market and euro zone equities.
EM equities are attractive in the medium term because they have a track record for growth: of the top four equity sectors in the EM Equities index, 3 are sectors linked to technology, social media and consumption. This track record is nevertheless well priced-in, with domestic and regulated sectors driving down the overall valuation of EM indices. We are becoming more constructive again on EM equities, and on China in particular with the assurance that a deal (even a temporary one) can be reached with the US and that the risk of a trade war has been avoided in the short term. As a result, China should be able to support its economic growth, and the EM zone could at least partially catch up performance-wise.

The euro zone is still looking more vulnerable, given its limited budget leeway, already negative yields and exposure to several internal and external political risks. Investors have already priced in these risks, however, and have turned their back on the region: equity flows have been negative since last year and their stance on the euro is also still very negative. Paradoxically, this pessimism could end up paving the way for a nice surprise in the form of stabilised growth or the easing of political tensions. In the meantime, investor caution regarding the euro zone can be seen in the record discount on value vs. growth strategies. A fair share of the equities market has been overlooked and has significantly underperformed the choicest quality and growth stocks (boasting higher valuations). At such an extreme level of discount, we may see a sudden and rapid shift in investment styles, but one that is likely contingent on better economic data and higher yields.

 

Our bond allocation promotes the search for yield

The Fed’s 180-degree turn (from policy normalisation to easing) has impacted our bond allocation, placing the search for yield squarely back in our sights.

The probability of a recession in the next 12 months is limited, which gives us the opportunity to invest in higher risk asset classes offering the potential for higher returns. Right now we like European HY credit and USD-denominated EM debt in a diversified portfolio.  Default rates are low and are liable to stay that way as economic conditions stabilise. 

 

In the wake of the sharp drop in yields since the month of May, we are underweighting European government debt.

 

Providing more structural protection for our portfolios

We are heading into a more uncertain phase of the economic cycle, fraught with many political risks and unpredictable communication effects. Now is the time to implement more structural protection, by gaining exposure to currencies like the Yen, which has played this role quite well so far this year.  



Gold also offers good protection in the current environment. We are also planning to buy volatility, which barely rose in May despite the equity market decline and the resurgence of US-China trade tensions. The monetary easing race currently being run by the major central banks has once again stomped out volatility. Even so, we know that volatility will begin climbing if investors start worrying again about recession, making it an effective hedge against any loss of confidence in central bank intervention.



In conclusion, we grew more cautious in May and sold a little, choosing to play it safe. But we haven’t given up and are sticking with an OW stance on US equities, HY bonds and EM debt. At the same time, we have introduced a few hedging strategies to our portfolios and are ready to adjust our allocation to any decisive newsflow on the political or economic front.