Quarterly Investment Strategy
Asset allocation: continue to seek yield and favour emerging assets – assuming markets will not be trumped
In a nutshell:
For now the “lower for longer” rates axiom remains in place, warranting continued yield-chasing in credit, real assets and high dividend stocks – such investments should be calibrated and diversified according to the risk appetite of each portfolio.
Continued oil stabilisation enhances the appeal of emerging assets: we maintain our overweight in both local currency-denominated debt and equities.
A Trump victory in the US presidential election might question the viability of the yield-chasing approach as well as the emerging markets stabilisation, leading us to reconsider our portfolio positioning.
Over the past few months, our asset allocation has rested on two main convictions: yields will stay “lower for longer” and the commodity complex is stabilising. Albeit challenged during the summer by volatility episodes in both the oil and sovereign bond markets, our decision to gradually steer portfolios towards higher yielding assets (with a preference for corporate over sovereign bonds) and the emerging space (via local currency-denominated sovereign bonds initially and then, from the end of July, equities) has been vindicated. With central banks likely to stay broadly accommodative for the coming quarter at least, we remain confident in our yield-chasing approach. Also, while acknowledging the bumpy road ahead – until the inventory glut is resorbed – we see greater willingness from oil producers, notably OPEC, to secure a floor for the oil price.
That said, we should point out that a time might come when these two convictions can no longer coexist – notably in the event that the oil price stabilisation starts to generate inflation expectations. A significant interest rate shock, say a 70-100 basis point surge, is clearly our main risk scenario. Unlikely to be confined to the fixed income universe, it would also threaten already extreme valuations on some equity indices/sectors, not to mention the dollar- and US rate-sensitive emerging space. At the current broad based low rate level, this risk cannot be underestimated, particularly once investors realize that central banks might have reached their limits. Indeed, the ECB seems less inclined to extend its unconventional/negative rates policies than markets initially believed, while the BoJ has clearly engaged in an attempt to steepen the Japanese yield curve. By contrast, the Fed has – again – postponed its long-awaited second rate hike, while still signalling its intention to tighten later this year. Investors are left with mixed feelings, facing seemingly schizophrenic central banks that are holding yields at ultra low levels while voicing a fresh desire to steepen curves in order to provide a breather to the financial sector. For now, although the market might test the “lower for longer” axiom more frequently – as it did in early September – we expect such moves to remain relatively contained both in time and in magnitude, given the relative attractiveness of treasuries in a zero rate environment, the subdued growth and inflation outlook and the tepid tightening cycle in the US.
From a portfolio perspective, the interest rate risk calls for greater cautiousness within the fixed income universe. Our long-dated underweight of developed market sovereign bonds has paid off, but we now see less potential from our overweight of investment grade (IG) bonds, with corporations having started to issue negative-yielding bonds in both the Eurozone and Switzerland. Given bond sensitivity that is sharply higher when yields near the zero bound and a carry that can no longer offset price moves, we have elected to take profits on IG credit and switch part of our exposure to the high yield segment. This should reduce portfolio sensitivity to rate volatility while taking advantage of the greater carry offered by those bonds. It is in effect the continuation of our “yield chasing” approach, particularly in Europe where the ECB and, more recently, the BoE are pushing investors down the rating scale by purchasing significant amounts of investment grade corporate bonds. In the US, with the stabilisation of the oil price between USD 45 and 50 per barrel, energy defaults should start to recede. After more than two years of distress, it seems very likely that most of the companies that could not adapt to the new oil market paradigm have already defaulted. US commodity sector aside, coverage ratios (interest expense relative to earnings) on both sides of the Atlantic stand at decent levels and we expect central banks to maintain loose financing conditions – even if the leverage cycle is obviously more advanced in the US than in Europe. In short, we opt for “business cycle risk” over “rate risk”, while still recommending selectivity and diversification in the best-rated part of the high yield segment.
In Swiss profiles, where August saw corporate yields join government yields in negative territory, investors can also rebalance their allocation towards listed Swiss real estate. This asset class still offers a dividend yield of 2.8%, the highest spread versus the 10-year Swiss government bond yield. Robust migration figures, together with still very low vacancy rates in rental residential real estate, should continue to support Swiss real estate valuation.
In a context where rate-fuelled episodes of volatility should be short lived, we expect limited spillover effects to other asset classes. It is true that alternative sources of volatility are not lacking, particularly on the political front with the forthcoming US elections (see box on the left), the Italian referendum, the continued struggle to form a Spanish government, not to mention continuous noise around “Brexit” negotiations. But the global macroeconomic picture has not deteriorated. Rather, as highlighted in the previous pages, global activity has rebounded from a weak 2nd quarter, led notably by manufacturing. As such, we think that the most likely scenario is one in which the current Goldilocks environment prevails for some more months. We could even see interest rates trend slightly higher for “good reasons”, namely stronger growth/inflation prospects. Reflation trades should thus outperform, as signalled by the rotation towards cyclical sectors in developed equity markets. We nonetheless keep a cautious stance as regards developed equity markets overall, given the sensitivity to interest rates implied by their stretched valuations. Certain sectors would not be immune, especially in the crowded low-volatility/high dividend segments.
By contrast, the stabilisation of the commodity and emerging market complex remains a valid assumption behind our portfolio construction process. Short-term risks do exist, mainly on the price of oil, as non-US supply continues to grow, postponing an eventual rebalancing of the market. Note, however, that emerging markets might prove more immune than in the past to an oil price correction given their under-owned positioning and the reduced sensitivity of global emerging indices to the commodity complex. While still higher than in developed markets, the commodity sector’s weight has been halved to 15% over the past four years. Also, and importantly, the latest informal discussions in Algiers between OPEC members show producers’ intent to secure a floor for the oil price and, in turn, stimulate the investments needed in the sector over the years to come. In this regards, the November OPEC meeting will be key as it should mark the return of production quotas – abandoned in practice in November 2014, then officially in December 2015 – and thus the re-emergence of the cartel as a key variable in the price equation. We thus recommend to continue to add emerging risk via equity markets. More precisely, given relative valuations and the supportive cyclical momentum, we would flag a preference for China.
Turning to forex, the past few months have been marked by greater differentiation between major currencies, with high volatility on the part of the British pound (GBP) and Japanese yen, and low volatility in the euro (EUR), USD and Swiss franc (CHF). The USD has been particularly stable within its 1.10-1.15 trading range against the EUR, although a repricing of expected Fed action and/or rate volatility does suggest an upward bias in the short term. Note, however, that we would not expect such a move to significantly hurt emerging currencies, and, in turn, threaten our portfolio positioning. The single currency might experience some volatility given the heavy political agenda that lies ahead, justifying the continuation of EUR hedges in USD and CHF portfolios for now. Finally, the GBP remains torn between surprisingly positive macroeconomic data and renewed noise around “Brexit” negotiations. We have thus adopted a more neutral stance, taking profits on the hedges implemented at the onset of the year.
What if? Potential impact of a Trump victory on our portfolio positioning
The portfolio positioning depicted in these pages is built on the base case of a Clinton victory, i.e. a scenario of policy continuity. But a Trump victory cannot be ruled out – leading us to consider how it would impact financial markets and flag potential hedges.
First and foremost, a Trump victory would translate into higher risk premiums, given the uncertainties surrounding his political program and the larger policy changes involved. Initially, US treasuries are thus likely to benefit from safe haven flows. Medium-term though, there are many aspects of the Trump program that should drive US yields higher, notably a larger public deficit (with infrastructure investments and tax cuts not funded by a rise in revenues, unlike the Clinton approach), the appointment of a more hawkish Fed Chairman and upward pressure on wages and imported inflation due to immigration and trade barriers.
In forex markets, larger fiscal stimulus, repatriation and protectionism should support the USD, especially against the Mexican peso and the renminbi (the Trump campaign having explicitly threatened Mexico and China with import tariffs of respectively 35% and 45%). Volatility and losses on these currencies should be exacerbated – China might retaliate by ending its intervention in the currency markets – and could spread to the rest of the emerging space.
In equity markets, following initial volatility, a reduction in the corporate tax rate (from 35% to 15%) would be supportive. Sector-wise, the main themes of the Trump campaign suggest outperformance of big pharma (repeal Obamacare), financials (dismantle Dodd-Frank), materials (impose tariffs on Chinese steel and invest in infrastructure), traditional energy (support energy production and deregulate exports) and technology (offer a repatriation holiday on foreign earnings).
For credit, higher financing costs are likely to be somewhat offset by the corporate tax cut. Despite high leverage, coverage of interest expense should thus remain sufficient to avoid a surge in defaults.
In conclusion, a Trump victory might question the viability of the yield chasing approach as well as the emerging markets stabilisation, leading us to reconsider our portfolio positioning.
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