A sweet spot, but keep a sharp eye on the macro side
Risky assets have been in a very strong uptrend since the beginning of the year. The key question now is, where do we go from here? There are two main driving forces to focus on in the current context.
Force 1 is the dovish turn of the main Central Banks (CBs) – the game changer this year. The Fed hiking cycle seems to be over for the moment, with the probability of further hikes now very remote. The ECB has gone the extra mile of dovishness by confirming that the “lower for longer” narrative is going to persist, announcing a new TLTRO, and also introducing the possibility of further accommodative measures.
Force 2 is the slowdown in global growth and the very limited inflation pressures, both of which form the rationale behind the dovish stance of the CBs. Macro data have been weak in the EU, and pockets of weakness are visible in the US as well. Going forward, we expect the EU economy to bottom out, and potentially improve in the second part of the year (barring the probability of a confidence shock), and we anticipate a slight deceleration in the US, while we see a very limited probability of a recession.
In the first quarter of the year, the looser monetary policies (Force 1) have clearly dominated. The biggest beneficiaries have been risky assets, as goldilocks trades have come back into vogue.
In a short-term view, chasing the market does not appear to be a smart move. Most of the valuation gap we highlighted at the start of the year has now been absorbed. Moreover, the pendulum of the prevailing driving force for the market could swing back somewhat from low interest rates (good news) to weak growth (bad news). Also, the move from the prevailing “bad news is good news” environment to the “bad news is bad news” mode is the major risk investors are facing right now, which is clearly important at a time when the peak in earnings is behind us and trade disputes are prevalent. In fact, it is still uncertain how far the bad news could go. A small taste of this uncertainty came two weeks ago when the ECB revised down its growth and inflation forecasts, and financial stocks suffered despite the new TLTRO announcement. But as long as the sweet spot is intact (ie, a consensus of CBs on the accommodative side and no further deterioration in the growth outlook), there will be some support for risky assets, even if the valuation gaps are less attractive.
We continue to see some opportunities in risky assets, but at the same time we suggest moderation in the deployment of risk budgets in view of the price action already seen. As we see limited directional upside ahead, we prefer to avoid areas where the risk profile looks asymmetrical in the short term (with more risk of correction than further upside). This is the case for equities, where we have become more cautious, with a preference for EM (where we are still constructive) vs DM (more cautious). A new entry point (especially for European equities) could emerge when the negative trend in earnings revisions bottoms out, and we believe this will happen, if we are right in seeing no further deceleration and some improvement in H2. In this “wait and see” phase, corporate markets (in particular in Europe) remain attractive. Going forward, it will be important to watch the macro side: the sweet spot could end if there is an increasingly deteriorating macro – and this is not our call. However, it will be a close call, and it will be crucial to identify any signal or factor that could jeopardise the persistence of the sweet spot, with an eye on risks that could worsen the scenario, such as a hard landing in China, a chaotic Brexit with negative consequences for European growth, and/or further escalation in trade tensions harming global trade.
On a medium-term view, beyond the cyclical moves and beyond any sweet spot, structural forces (demographics, low structural inflation) will continue to keep interest rates down. Facing lower expected returns, investors have no option but to be able to identify and exploit value where it lies or where it is restored. This implies being systematic and quick – and this is one of the key lessons learned this year, given the speed of the market moves this year to date.
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