Quarterly Investment Strategy
ASSET ALLOCATION: INVESTING BEYOND THE PANIC
In a nutshell
- Stabilising US dollar and oil prices appear to be triggering a major rotation towards value assets, such as emerging markets.
- The US Federal Reserve (Fed)’s – for now – dovish stance should allow the current risk-on momentum to continue through the 2nd quarter, while the European Central Bank (ECB)’s latest measures clearly support credit markets.
- Our positioning is vulnerable to any US dollar strengthening – to the extent that such a scenario would develop only in the event of rising inflation expectations and consequent Fed repricing, our favouring of Treasury Inflation Protected Securities (TIPS) over US nominal bonds should act as a hedge.
- Investment grade credit is likely to outperform government bonds in the US and Europe, while high yield European paper should deliver decent returns. Selectivity remains key in US high yield.
The start of the year has been particularly shaky, with renewed concerns on China, the US manufacturing sector and oil prices fuelling extensive equity market turmoil. Although the collapse in oil prices proved more pronounced than we had expected, we hold to our baseline scenario of low but stable global economic growth. With many assets looking expensive, this implies that returns will be low and volatile. As such, we think the key to investing during coming months will be to be able to look through the inevitable volatility episodes and take advantage of what opportunities they bring. When reviewing our last letter, we feel comfortable with most of our key calls for 2016. Interestingly, we had mentioned a stabilisation of the US dollar and oil prices as a trigger for a major rotation towards value assets, such as cyclical US sectors and emerging markets. We think this is precisely what is currently occurring – even if further confirmation is required as regards the US manufacturing sector – and have started to position our portfolios accordingly. Meanwhile, the ECB’s additional stimulus, exceeding market expectations, appears to be another game changer, especially when it comes to European portfolios. Finally, the potential for a Britain to exit the EU (Brexit) adds uncertainty to sterling-based portfolios, and spillover effects to euro-based portfolios cannot be excluded. All told, we think that time has again come to differentiate portfolios.
As just mentioned, oil and currency stability remain central to our investment stance. As the risk that inventories reach storage capacities fades, oil prices have finally found a floor. Spring should bring about a decline in inventories, as reflected by the restarting of refineries. That said, production outside of the US has been more resilient than would have been expected in such a low price environment. While the agreement between some OPEC (Organisation of the Petroleum Exporting Countries) members and Russia to freeze output at January levels was a strong factor behind the recent rally, it might actually have little impact unless Iran were to join the deal with a reasonable production target. So although downside risks have diminished, commodity volatility is here to stay until supply cuts and capex discipline gradually narrow the oversupply situation.
Relative stability might be how best to describe behaviour of the foreign exchange (forex) market over the last couple of months. Most developed market currencies (euro, Swiss franc and US dollar continue to trade within their ranges, even though intraday moves can be substantial. For example, the euro strengthened markedly against the US dollar following the ECB meeting that ruled out further rate cuts, and even more so after the dovish Fed meeting (gaining more than 2% vs the dollar on the days after each of these meetings), but the pair still kept to the 1.05-1.15 channel that has been in place for the past twelve months. The importance of forex stability was again highlighted during the last G20 meeting held in Shanghai and the People’s Bank of China (PBoC)‘s ability to somewhat steady the renminbi has perhaps played a role in this overall “relative stability”. Making for notable exceptions have been the Japanese yen and pound sterling, both for specific reasons (unconvincing BoJ action and Brexit risk). Interestingly, these are the two currencies that have attracted the largest speculative positioning (investors shied away from other currencies). Going forward, we expect forex markets to remain directionless, volatile but prone to significant swings as central banks act to maintain currencies within ranges. Investment-wise, our hedging policy is now focused mainly on the Brexit risk but we stand ready to adapt it should currencies re-test the lower/higher ends of their trading ranges.
The month of March saw central banks have a broader impact, beyond just forex, on our cross asset outlook and portfolio positioning. First, the shift in ECB focus from negative rates to quantitative and credit easing has sharpened our preference for credit over sovereign bonds in the Euro area. ECB corporate bond purchases will focus on investment grade paper (excluding banks), but we think that they will trigger significant inflows also into the high yield space, due to investor displacement (increased size and scope of the ECB asset purchase program) and to low defaults as a result of easier financing conditions (banks enjoying targeted longer-term refinancing operations with possibly negative rates). In the US fixed income markets, selectivity remains crucial as financing conditions should continue to tighten during coming months. The recent rise in default rates in the materials sector (from 3.9% in December 2015 to 8.5% in February, according to Merrill Lynch data) calls for a cautious stance, with flows likely to be less supportive than in Europe.
The second central bank “surprise” of March was the dovish outcome of the Fed meeting, indicating that US monetary authorities have become increasingly responsive to financial conditions. We are wary of this sensitivity, since the tightening intentions previously displayed by the Fed played a part in the very market volatility that it now finds disturbing. This meeting also confirmed our view that a rise in inflation expectations should not be excluded. Has the Fed successfully revived the reflation trade? Its willingness to fall behind the inflation curve is likely to support our preference for TIPS over nominal bonds in the US in the months to come, as well as possibly fuelling higher term premia – a bear steepening of the US yield curve would not surprise us.
What does this mean for equity markets and, more generally, risk positioning? The contrarian and disciplined approach that we described last quarter led us to rebalance our equity exposure on the recent rally, bringing it back to neutrality. With most recent data showing tentative signs of stabilisation in the global industrial sector, increasing risk exposure is admittedly tempting. One month does not make a trend, and we would need to see more evidence, but the market has clearly started to bet on a cyclical rebound. That said, as US markets approach our year-end targets, we must also remember that their current positive momentum may ultimately be stopped by slightly more hawkish Fed rhetoric. Since lower overall index returns do not preclude a high dispersion of returns within the index, sector positioning will be crucial to maintain performance going forward.
Turning to European markets, the latest ECB measures have several implications: (i) preserving the banking sector’s margins; (ii) boosting credit growth; and (iii) precluding further support from euro depreciation. As such, the banking sector underperformance is likely to reverse, with the broader earnings impact perhaps materialising as soon as the 2nd half of this year. Following sharp downward revisions during the 1st quarter, analyst expectations could prove rather easy to beat as the year unfolds, barring excessive euro strengthening. Fundamentals are clearly becoming more supportive but, given the growing number of potentially stressful events, we continue to find the risk/return profile of European credit more attractive than that of equities – thus keeping our neutral stance on the latter.
Finally, as regards emerging markets, the dovish Fed and more stable dollar/commodity complex make for an improved financial environment. After more than five years of de-rating, the worst might now be priced in. Specifically, we think that emerging currencies may have found a bottom against the US dollar. As hinted in last quarter’s letter, we have initiated a long position in emerging local debt. This not only diversifies portfolios away from developed market equity risk (as compared to developed market credit positions) but also brings significant carry benefits: local government bonds in emerging markets are yielding an average 6% for a 4.7 duration. In order to gain exposure to the commodity trade we have also upgraded emerging equities to a neutral stance. We are well aware that these moves have increased our vulnerability to any strengthening of the US dollar. Favouring TIPS bonds constitutes, in our view, a means to hedge this risk, while preserving most of the safe-haven characteristics of US nominal bonds. Indeed, only in the event of rising inflation expectations and, in turn, Fed repricing do we foresee a stronger greenback.
How can portfolios be hedged against a potential Brexit?
With polls currently suggesting a close outcome, the risk of a Brexit should be acknowledged and hedging strategies be implemented. As the most liquid UK financial asset, the pound sterling is also the most vulnerable to Brexit fears. We would expect most of the depreciation to be against the US dollar and Swiss franc, with the euro likely to be affected by fears regarding future EU cohesion. Although the rise in risk premia has so far been mainly confined to UK assets, we anticipate that volatility will increase across both UK and European markets ahead of the referendum. Peripheral spreads might also come under pressure because of the institutional issues, but ECB purchases are likely to limit their widening. To date, large caps have been cushioned from Brexit concerns by currency depreciation and other external positive factors, notably rising commodity prices, but a significant market decline cannot be ruled out. At this stage, we favour option strategies to hedge the risk of Brexit rather than cutting equity exposure outright. In addition, we have implemented a partial hedge of sterling exposure in dollar- and Swiss franc-based portfolios, bearing in mind that, by a mirror effect, a bounce back of the depressed UK currency would be likely if voters decide to remain part of the EU.
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