All assets have rallied recently, partly on the back of central bank dovishness. But, late in the economic cycle and with Europe’s and China’s growth structurally challenged, downside risks remain. Goldilocks is on edge.
The central bank pivot – and especially the Fed’s message – should continue to squeeze market volatility, lower real yields and thus reinvigorate investors’ search for yield.
We are currently looking for carry opportunities. Emerging market debt looks interesting from a carry perspective. From a currency perspective, we prefer hard currency debt just now – as the US dollar appears overvalued to us with the Fed having paused its policy tightening, EM local debt may at some point offer additional value.
Don’t chase growth assets higher at this juncture
While selective carry trades look attractive, we are wary of chasing risky assets higher (see Exhibit 1)
Exhibit 1: Returns of selected asset classes in first quarter 2019 – all assets up
Source: Bloomberg and BNPP AM, as of 29/03/2019
We have been structurally neutral equities for some time now – previously arguing that the combination of downside risks to the macroeconomic outlook and equities priced mid-range in our scenario analysis made the asset class unattractive.
With stocks rallying further in recent weeks, however, a lot of the good news now appears to be priced in and an asymmetry to the downside is starting to open up.
Put differently, we see equities as vulnerable to growth setbacks and have recently established a tactical short in developed market equities.
Exploiting asymmetries and building robust portfolios
Given the uncertain macroeconomic backdrop, we believe that building robust portfolios and holding diversification trades is crucial. Our scenario analysis is useful in this regard as it helps us identify where asymmetries are building and hence where risk/reward is likely to be attractive.
In addition to equity market asymmetry developing to the downside, there are some interesting opportunities in fixed income, which we are positioned for.
There remains a stark valuation differential between US and German bond yields and we remain in a relative value (RV) trade long 5-year US bonds versus 5-year German bonds. This trade is not just attractive because of stretched valuation differences; it also has good defensive characteristics in risk-off environments, with US yields having ‘more room to drop’ in a slowdown scenario. This makes the RV trade a good portfolio diversifier.
In terms of duration, we are still underweight EMU bonds. Recent price movements have brought the rationale for this position (stabilisation in growth, gradually rising inflation and monetary policy normalisation by the ECB) into question. This is especially so, given the weakness in recent data releases, most notably PMI data.
While Bund yields continue to exhibit an asymmetric outlook to the upside in most of our scenarios, the triggers to unlock this value are becoming less clear. We are currently reviewing both our tactical and strategic position, looking to possibly reduce our exposure.
Elsewhere, to build robust portfolios, we are continually exploring trades which are geared to thematic views.
After much angst not too long ago, investors have seemingly forgotten about China and protectionism risks. We continue to think that ‘old China’ remains challenged, and that protectionism forces are here to stay, albeit while also improving and deteriorating in short term cycles around the long-term deteriorating trend.
We believe recently weak data from Germany and other major manufacturing economies reflects these forces. Thus, we remain long the French CAC 40 and short the German DAX. As Germany is more exposed than France to de-globalisation, this relative value trade aims to reduce our exposure to possible renewed trade tensions between China and the US.
In conclusion, here is how we are approaching the second quarter:
- Looking to be long carry… The Fed’s message, all else being equal, should continue to curtail volatility, lower real yields and revitalise the search for yield. We are currently looking for carry opportunities, with EM debt looking attractive.
- …But not chasing growth assets – Equities do not look attractive to us. A lot of the good news appears to be priced in and we see the asset class as vulnerable to growth setbacks. We have taken a tactical short position in developed market equities.
- Exploiting asymmetries – Our scenario analysis helps identify where asymmetries are building and where risk/reward is attractive.
- Building robust portfolios – Given the uncertain macroeconomic backdrop, we regard building robust portfolios and holding diversification trades as crucial at this point in the cycle. We hold several positions/RV trades with asymmetries.