Finding the balance between sound fundamentals and a growing set of risks

investment insights

Finding the balance between sound fundamentals and a growing set of risks

Sophie Chardon - Cross-Asset Strategist

Sophie Chardon

Cross-Asset Strategist
Vasileios Gkionakis, PhD - Global Head of FX Strategy

Vasileios Gkionakis, PhD

Global Head of FX Strategy

In a nutshell

  • Late-cycle phases can offer robust returns but pose new challenges, as the cost of capital is rising, and demand careful management of risk, particularly liquidity risk.
  • We have thus reduced exposure to assets likely to prove least liquid in the event of a downturn, notably emerging market assets and convertible bonds.
  • Our exposure to emerging markets is now neutral: in the most vulnerable economies, sharp currency losses threaten to affect (improved) structural dynamics, with the pick-up in inflation forcing central banks to adopt a less accommodative stance.
  • We will rigorously monitor market conditions and remain nimble in our tactical asset allocation – keeping the overall risk level close to our Strategic Asset Allocation while maintaining selective cyclical exposure, so as to benefit from the still sound global fundamentals.

The past quarter has proved tough for risk assets, with emerging market turmoil and mounting uncertainties weighing on performance. The most meaningful bastions of strength have been the US economy and stock market, in part thanks to the ongoing fiscal package. The corollary is that the Fed will have no choice but to continue to tighten US financing conditions, regardless of the international impacts. Consequently, we have engaged in a gradual reduction of our overall portfolio risk level.

We began 2018 in a “goldilocks” economic environment (i.e. strong growth and low inflation), with well-oriented markets and a relatively high level of risk relative to our newly initiated Strategic Asset Allocation. We were notably overweight emerging equities, small-cap equities, high yield debt, as well as emerging debt in both hard and local currencies. We maintained this pro-risk stance throughout the 1st half of the year, even though we foresaw lower future returns and more episodes of volatility as the “goldilocks” period came to its end in the US. Since June, we have been aiming for a more neutral stance. We have reduced exposure to emerging debt (in hard and local currencies), convertible bonds and equities. Indeed, as the US cycle advances, the most vulnerable economic actors find themselves challenged by a rising cost of capital. We feel that the risk of financial market accidents is increasing and it is time to be more selective.

Summer emerging market turmoil provides a good illustration of what a maturing US cycle means for financial markets (see chart XII, page 09). Although the currency crises do have idiosyncratic roots, they are intensified by the Fed’s continued tightening. The fact that emerging central banks are in turn being forced to become more restrictive, in reaction to their devaluating currencies, is only adding to the pressure on emerging assets. We have taken a number of steps over the past months to reduce exposure to emerging market risk. We started in May by cutting our overweight of local currency-denominated emerging debt in USD portfolios. In June and July, we then cut our overweight of, respectively, emerging equities and hard currency-denominated emerging debt. Finally, in September, we further decreased our holdings of local currency-denominated emerging debt. Across the various risk profiles, our emerging market exposure has thus now been brought back to neutral.

The decision to focus the latest reduction on emerging bonds rather than equities was based on two considerations. First, countries with poor fundamentals represent a large share of the bond market (see chart XIII, page 09) whereas countries with good fundamentals make up 75% of equity indices. Second, we note that back in 2013, when the Fed announced the tapering of its quantitative easing program (which was a source of dollar tightening comparable to today’s), local currency-denominated emerging debt underperformed other asset classes. Interestingly, emerging equities have also historically shown a tendency to rebound faster than bonds, meaning that holding on to this exposure should enable portfolios to benefit from a potential bounce.

As regards developed market equities, the main striking fact has been the continued divergence in performance between the US and other regions (see chart XIV, page 11). This divergence is mainly attributable to fears of a trade war and its potential impact on export-driven economies (Europe, emerging markets), but also reflects impressive earnings dynamics in the US (see chart XV, page 11). In line with the changes initiated in May, we recently elected to further reduce active risk within our regional allocation. Current political uncertainties pertaining to the Italian budget, relative valuation, earnings momentum and a lack of positive short-run catalysts all contribute to making Europe seem lessattractive than we previously thought. Our exposure is now back to benchmark in all regions except for Japan, where we remain overweight. Japanese equities are cheap and bring a pro-cyclical tilt to our equity allocation.

In fixed income, unattractive expected returns, especially in the European sovereign and credit segments, continue to warrant a defensive stance. In USD portfolios, we have started to buy some short-term paper, reinvesting the proceeds from the sales of emerging debt and European equities. But we recommend maintaining a short duration and underweighting the high yield segment, as yields (i.e. the cost of capital) have room to rise further. In EUR, CHF and GBP portfolios, yields are still too low to make a similar move – we thus kept the proceeds in cash. As described earlier, our stance on emerging market debt, both hard- and local currency-denominated, is now neutral. And we remain slightly overweight convertible bonds.
 

In fixed income, unattractive expected returns, especially in the European sovereign and credit segments, continue to warrant a defensive stance. In USD portfolios, we have started to buy some short-term paper, reinvesting the proceeds from the sales of emerging debt and European equities.


Turning to currency markets, we expect the US dollar to stabilise in the near-term, as this year’s upward drivers wane, and then depreciate on a 12-month and beyond horizon (see Box A, page 12). Elsewhere in the G10, we look for upside on the Canadian dollar and Norwegian Krone (due to strong oil prices and tighter monetary policy), while expecting the pound sterling to continue to be driven almost exclusively by Brexit headline risk. Finally, we anticipate a resumption in Swiss franc weakness although the process is likely to be particularly slow. As regards emerging currencies, we suggest cautiousness and selectivity: cautiousness because (i) there are downside risks to global growth and (ii) higher US yields are likely to weigh on externally vulnerable emerging market economies; and selectivity because, in the late stages of the cycle, investors typically reward currencies with strong economic fundamentals.

Among the emerging FX universe, we favour the Russian ruble (on oil price grounds) and Mexican peso (due to positive spillovers from US growth and resolution of the NAFTA – North American Free Trade Agreement – negotiations. We are turning neutral on the South African rand, as we feel the currency will be subject to opposing forces: too much negativity already in the price on the one hand but looming domestic and external growth risks on the other. Finally, we think the Turkish lira will resume its weakness as higher inflation has pushed real yields back into negative territory and high energy prices are starting to bite on consumer firepower.

Within the commodities space, our preference goes to oil (see Box B, page 13) and base metals. The latter market saw considerable Chinese destocking during the period of dollar appreciation, meaning that the world’s largest consumer will need to come back to the market – all the more so if it implements a domestic stimulus plan. With physical supply/demand currently at equilibrium, and extremely bearish investor positioning, the upside on base metals could be material if stronger manufacturing data is reported or the trade dispute shows any signs of waning. As for gold, while it remains the ultimate hedge against an “end of the world” scenario, its attractiveness is limited by rising US yields – in the wake of a quite normal return of inflation. Physical demand in large gold consuming countries, such as India and China, will likely suffer from currency depreciation and seems little inclined to pick up soon.

FX view: US fiscal policy will prove the dollar’s Achilles heel

On a trade-weighted basis, the dollar is up 7% since mid-April (3% year-to-date). Its momentum was particularly strong through late June, with price action more two-way over the last few months. We attribute the summer uptrend to three (interrelated) factors. First, a slew of idiosyncratic risks flared up in emerging markets (Turkey, Argentina and Brazil), with typical spill-over effects on risk appetite – driving investors to safe haven assets such as the greenback. Second, the 2-year real yield differential between the US and its seven most important trading partners widened from 129 bps (basis points) at the end of January to just over 180 bps (see chart XVI, page 12), due to continued Fed policy tightening while the other major central banks stood pat. Finally, activity indicators have moderated outside of the US, with the trade dispute also contributing to dampen sentiment about world economic growth.

These forces are likely to wane – though will not disappear completely – over the next few months. For starters, the pockets of country-specific risk have mostly been contained. While Brazilian political developments do warrant close monitoring, given the country’s prominence in emerging market indices, the majority of emerging economies have reduced their external imbalances. Vulnerable and high beta emerging FX could see bouts of selling but we doubt that – absent a global growth shock – emerging market currencies will see a pronounced and sustained weakness.  As regards real yields, although monetary policy is set to continue to tighten in the US, higher inflation relative to the rest of the world should keep the differential from widening further. We also note that the later stages of Fed tightening have historically not been a barrier to USD depreciation. In the prior three rate cycles, dollar returns were quite poor once the Fed had covered about 60% of the hiking ground – which is more or less where we think we are currently. In 2004-2006, the trade-weighted dollar shed 2.6% as the central bank kept on raising the policy rate (from 3.25% to 5.25%), and in 1994-1995 it was more or less flat as the final hikes were made (before depreciating sharply). Only in 1999-2000 did the dollar manage to gain 4% as the policy rate rose from 5.75% to 6.5%. But this was a materially different period: financing costs were significantly higher than today, and emerging growth had been declining sharply since 1996, amid a large number of external crises. Finally, while global activity has admittedly shifted to a lower gear, recent PMI (Purchasing Managers’ Index) data still suggest a growth rate of around 2.5% for world GDP.

Dollar stability thus seems the likely path for the near term. On a medium-term horizon, however, the elephant in the room is US fiscal policy. Although it has clearly had an immediate positive impact on the economy, it lacks the productivity-enhancing measures that would raise output growth sustainably. It also came at exactly the wrong time in the cycle, just when the output gap was turning positive. In fact, accounting for the latter, fiscal policy is now the loosest in decades and bodes ill for the future of the dollar (see chart XVII, page 12). Such ill-timed debt accumulation is bound to raise US risk premia – particularly since the US have been the recipient of record inflows during the past decade – and weigh on the dollar. Looking out a year and beyond, our forecast is thus for the greenback to depreciate, with the EURUSD moving above 1.20 and the USDJPY towards 110 and below.


Oil price: upward-skewed short-term risk

At USD 86 per barrel, the Brent oil price is trading at its highest level for the year, indeed since October 2014. The expected drop in Iranian exports accounts for much of this strength, with large Chinese and Indian refiners reportedly the latest to halt purchases of Iranian crude, following the drop in exports to Europe that was reported in June/July.

The Iranian disruption (alongside the difficult Venezuelan and Libyan situations) makes for a deteriorating near-term oil supply outlook (see chart XVIII, page 13). Our base case has Iranian exports falling 500’000-1’000’000 barrels per day as a result of US sanctions, while Venezuelan output should stabilise at the current low level and Libyan production should average 1’000’000 barrels per day – while remaining volatile. We expect OPEC (Organization of Petroleum Exporting Countries) to stay intent on meeting consumer needs at a “fair price” but not overproducing the physical, showing an unwillingness to increase output pre-emptively (see chart XIX, page 13). With demand showing no signs of slowing down and the US administration proving reluctant to tap into the Strategic Petroleum Reserve, this new framework makes for upward-skewed risk to the oil price during the next quarters.
 

With demand showing no signs of slowing down and the US administration proving reluctant to tap into the Strategic Petroleum Reserve, this new framework makes for upward-skewed risk to the oil price during the next quarters.


The spectre of a return of the US shale industry, the famed swing producer, should not affect market dynamics in the short term. Indeed, even though current oil prices are likely to generate additional cash flow and thus capital expenditure, the lack of infrastructure in the Permian basin limits output for the time being. New pipeline capacity out of this basin is, however, scheduled for the latter half of 2019, anchoring our medium-term oil price forecast at USD 75 per barrel. 

For the oil price to move sustainably higher, another supply catalyst beyond Iran would be needed. Keep in mind also that, in the current strong dollar environment, any short-term price spike might eventually weigh on demand, notably from China and other emerging markets. We thus expect the Brent price to return to the USD 70-80 range towards the end of 2019. We nonetheless confirm our recommendation to maintain oil exposure in portfolios, given the positive carry implied by the current backwardation of the futures curve (ca. 7-8% per annum) and oil’s hedging virtues with respect to geopolitical tensions – a risk that cannot be totally excluded after the US mid-term elections, given escalating US posturing in the Middle-East.

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