Back to positive fundamentals? How to cope with rising uncertainty

investment insights

Back to positive fundamentals? How to cope with rising uncertainty

Sophie Chardon - Cross-Asset Strategist

Sophie Chardon

Cross-Asset Strategist

In a nutshell

  • With the soft patch experienced by non-US economies now likely over, fundamentals should run strong, underpinning our pro-risk stance.
  • More synchronized growth means lesser US dollar pressure on financial markets, removing one of the main headwinds affecting our current portfolio positioning.
  • That said, we acknowledge that the business cycle is advancing, making growth assets increasingly sensitive to potential macroeconomic and political challenges – as uncertainty rises, we continue to seek exposure to asymmetric trades.
  • Economic overheating in the US, fuelling disruptive Fed action, and/or an intensification of protectionism remain the two main risks to our baseline scenario. We will continue to closely monitor the US yield curve, the US dollar and upcoming global trade data releases, and be prepared to adapt our asset allocation accordingly.

Mid-year is an opportune time to take a step back and review our key calls for 2018. While our expectations of a shift towards lower financial asset returns and higher market volatility, fuelled by inflation and monetary policy, proved correct, geopolitics appear to have had a greater impact than initially anticipated. Since last quarter’s publication, political developments have definitely taken centre stage, both in developed (Italy, US trade tariffs) and emerging (elections in Turkey, Brazil and Mexico) countries. And it would be unfair to say that financial markets remained immune to this unstable backdrop (see chart XI, page 09).

Political newsflow intensified just as the global business cycle was proving somewhat disappointing, with the notable exception of the US economy – whose unilateral upturn is at least partly attributable to the fiscal impulse. Hence the strengthening of the US dollar, and its traditional victims: emerging markets. We will closely monitor developments on this front, as the Fed’s monetary path could prove disruptive in an environment where other major central banks (ECB and BoJ) are still somewhat more accommodative. At this point, however, we believe that markets have largely priced in Fed and ECB action during the next quarters (see chart XII, page 09), warranting our recently updated neutral stance on the EUR/USD (from 1.23 to 1.20 on a 12-month horizon).

For trade disputes to turn into full-blown war is not our base case, meaning that we expect no significant dent to global growth. The latest Purchasing Managers’ Index (PMI) releases signalled an upturn in most cyclical economies – usually a good leading indicator (see chart II, page 04). We will be watching out for an indirect impact on capital expenditures (capex) via business confidence, should the negative newsflow persist for too long. Company guidance during the 1st quarter earnings season was still well-oriented, with no concern expressed about potential tariffs in the US and capex expected to pick up in coming quarters, but the pending 2nd quarter earnings reports will certainly provide more information on this topic. Indeed, with Chinese authorities turning more vocal on qualitative retaliation options, the outlook could worsen for US companies that generate significant revenues in China or intend to invest in new production capacities there. Specifically regarding the US economy, as already mentioned, tariffs amount to a typical negative supply shock (falling output, rising prices), a situation which could eventually lead to a tighter monetary policy. With the long-end of the curve capped by policy uncertainties (the 10 year term premium remains anchored in negative territory), a more rapid flattening of the yield curve cannot be excluded, should the situation worsen.

Against this backdrop, we have begun a gradual process to lower our active risk. First, we neutralized our exposure to local currency-denominated emerging debt in USD portfolios. With cash starting to become attractive in the US and likely to trend higher based on Fed guidance, the relative value between the two asset classes was becoming less obvious (see chart XIII, page 10). On the other hand, we maintain exposure to emerging debt in EUR, GBP and CHF portfolios, given the still attractive carry. Going forward, our neutral stance on the greenback should prevent further losses on the forex side, while historically low inflation levels preclude a surge in interest rates. Emerging debt labelled in hard currency will of course remain sensitive to US interest rates. But even if there is some risk of overshooting, it should prove temporary, leading us to maintain our exposure.

We then lowered the active risk inherent in our regional equity allocation, reducing the US equities underweight relative to European and emerging equities. Indeed, with the US 12-month price/earnings ratio approaching its long-term average of 16x, the valuation argument is no longer pertinent (see chart XIV, page 10). Also, US earnings momentum is favourable, driven primarily by second-round effects now that the fiscal plan is in full swing. We maintain a (smaller) overweight in European equities, believing that the recent period of soft economic data should prove temporary and that prospects for positive growth surprises are compelling. But our exposure to emerging equities has been cut to neutral, meaning that our Tactical Asset Allocation is now aligned with our Strategic Asset Allocation – bearing in mind that the latter is well-loaded in emerging risk following the changes operated last September (see Investment Strategy 4th quarter 2017). In effect, we have taken profits on the emerging equities trade initiated two years ago, considering that earnings momentum and valuation offer less relative appeal in the short term, and volatility could persist at least for the next quarter. We do, however, maintain a positive stance on the Pacific region, including Japan, where market reforms are deploying their effects and the fundamental backdrop remains solid. From a sector perspective, we have upgraded US banks and telecom to overweight (from neutral and underweight respectively), and industrials to neutral. Finally, our positive view on the small-cap segment still holds, given its greater exposure to reflation and tax policy, and lower sensitivity to trade risk.

In the fixed income space, while we continue to prefer credit to sovereign bonds, the attractiveness of the asset class has deteriorated further in EUR and CHF markets, leading us to cut exposure for the second time this year. With indices’ duration at historical highs, credit is increasingly vulnerable to interest rate volatility. Given the current depressed level of coupons, we see no plausible scenario that could yield positive returns, or even exceed cash returns. Under our base case (10-year Bund yield at 0.80% and slightly wider credit spreads), expected returns are negative. Should the economic activity accelerate, the rise in rates and moderate spread tightening would also lead to negative returns. And in an adverse scenario, the drop in interest rates would be insufficient to offset spread widening.

However, because we believe that the current economic backdrop continues to support value creation in the corporate space – and given the still low yield on cash in EUR and CHF – we reinvested the proceeds into hedge funds. While posting a low beta, equity long/short managers are well-positioned to benefit from rising sector and stock dispersion. Dispersion across instruments has also been high, and macro managers are expressing more diverse opinions today than in recent years, which should both limit crowded trades and enable the best managers to prosper.

Turning to currency markets, we have revised our target for the EUR/CHF from 1.20 to 1.18, to account for short-term political uncertainty in Italy. We maintain a positive view on the yen, pending an official change in the BoJ’s policy stance. As for the GBP, it should continue to suffer from volatility as the most fundamental issues around Brexit (Northern Ireland, custom arrangements) are still unresolved.

In conclusion, with the soft patch experienced by non-US economies during the first months of the year expected to prove temporary, we maintain our long growth assets positioning, favouring corporate over sovereign risk and seeking exposure to more asymmetric trades. As such, following prior forays into the yen (on which we took profits in May) and convertible bonds (which we still hold), we used part of our cash holdings to increase exposure to commodities in April. This asset class can bring asymmetry to a multi-asset portfolio: its returns should be decent in our baseline scenario (mainly thanks to base metals), while the downside should be limited by the capacity constraints on the supply side, with even significant upside for oil and/or gold, should any of the risk scenarios materialise. That said, the level of uncertainty surrounding the political and, in turn, financial landscape makes us particularly vigilant and prepared to take action should the indicators we monitor worsen significantly.

OPEC committed to stabilising oil prices

At their late June meeting, OPEC (Organization of Petroleum Exporting Countries) and Russia secured an agreement to increase oil supply by as much as 1 million barrels per day, starting 1 July. They also discussed how to bring compliance to 100% – versus the near 150% level experienced since January 2017, due notably to the plummeting of Venezuelan output (see chart XV, page 14).

Only a handful of OPEC members (Saudi Arabia, Kuwait, UAE), alongside Russia, have the capacity to increase production at short notice. Saudi Arabia confirmed that it has already ramped up exports, while the Russian Minister of Energy indicated that the rise in Russian exports will be more gradual, depending on additional drilling.

As a result, despite this agreement, the oil market should at best be balanced this year and perhaps even suffer from undersupply, if demand rises faster than the International Energy Agency is forecasting. For 2019, we expect a rather balanced supply-demand situation. Inventories may grow modestly in absolute terms, while remaining lower than their five-year average (see chart XVI, page 11). Given more limited spare capacity and the lack of investment during recent years, oil could, however, become more sensitive to disruptions and geopolitics.

What does this mean for our investment case? We continue to favour commodities as an asset class, providing a hedge against geopolitical and inflation risks. Our view on oil remains neutral, with a target price of USD 70. OPEC is clearly still committed to defending this price level, comfortable for both producers and consumers.

Short-term, with additional Saudi exports not to be delivered before August, the oil price will remain underpinned by the recent pick-up in outages (Libya, Nigeria, Canada). Strong backwardation (i.e. price of futures below spot price) will persist, offering carry opportunities for investors.

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