INVESTMENT STRATEGY LETTER - December 2019

Florent Brones

Summary:

  1. Our convictions for 2020: a) economic growth will remain moderate and without inflation, we exclude the risk of a recession provided that a truce is signed between the United States and China; b) bond yields will remain low, and c) stock markets will deliver positive returns thanks to rising profits and dividends. Flows into equities will continue, and d) we need to diversify our bets as volatility will return from time to time during the year.
  2. After two months during which we have shifted a lot towards more optimism, we are not making any recommendation changes this month. We have remained long on the United States, the eurozone, the United Kingdom and the Emerging Markets since last month. In terms of sectors, we are buyers of European technology, US financials, insurance (in both Europe and the United States) and European building materials. In terms of style, we prefer value to growth and small- and mid- caps versus large caps. We recommend buying European convertible bonds.
  3. No changes to our long-term interest rate targets; in 12 months we expect 1.75% for the 10-year Treasury bond and -0.50% for the German Bund. The same is true for the dollar: our 3-month forecast remains unchanged at 1.12 for €1, i.e. a slight drop from the current level. Subsequently, we forecast a further decline in the dollar to 1.14 in 1 year.
  4. We reiterate our positive view on gold for its diversification virtues (forecast range of $1400-1600). Neutral views maintained on industrial commodities and oil (range of $60-70 for the Brent).
  5. In Alternative investments, we keep our preference for the Global Macro and Long/Short Equity strategies.  We are neutral on European REITs.

Our convictions for 2020

Even though the year is not over yet, we can say that 2019 was a good year for financial markets. Admittedly, it compensated for 2018, which was a difficult year. What will happen next year? Below are our convictions.

Moderate economic growth and low inflation

For more than a year, global industry has been in a recession, and leading economic indicators predict that this trend is not about to reverse. The industrial recession stems from trade tensions between China and the United States, and a contraction in the automotive sector. We believe that this industrial recession will not spread to the rest of the economy; services and job creation remain strong enough (particularly in the United States and Germany) for the overall growth of the economies to be positive, albeit slowing. Wage growth is supporting consumption without accelerating core inflation.

In other words, the longest economic growth cycle in history in the US will continue without a recession in 2020. Leading indicators are starting to stabilise. If this is confirmed in the coming months, a rebound in activity will start in the second half of the year, and the duration of the growth cycle will be extended in 2021.

One crucial condition must be met: political risks have been contracting since the autumn, and this easing needs to be amplified, particularly with the signing of a partial agreement between the US and China. Similarly, a negotiated Brexit must be finalised after the general election on 12 December.

Interest rates and bond yields remain durably low

This is a new paradigm, based on a widespread idea.  Interest rates are low, across all curves, and will remain so for a long time. Central banks are dovish and are communicating on a continuation of this policy in the foreseeable future. The ECB continues to use all the tools at its disposal, including negative official rates, very favourable TLTROs, a tiering system to help banks and, above all, a new phase of Quantitative Easing with monthly purchases of €20 billion-worth of bonds on the markets. The Fed has put things on hold after cutting its rate three times in 2019, and we think it will make two more rate cuts in 2020. Many other central banks are maintaining a dovish bias.

Bond rates are also very low; they have bounced back slightly from their lows over the past few few weeks. We believe that they will remain at around current levels (in 12 months, 1.75% for the 10-year US Treasury bond, 0.50% for the Bund): low inflation, moderate growth, continued monetary accommodation, excess savings, etc.

There is one scenario in which bond yields could rise more than expected: namely if aggressive fiscal stimulus policies were adopted to take over from monetary policies at the end of the cycle. This is the wish of central banks, particularly the ECB, on condition that States invest. For now, reflation measures remain very modest, particularly in countries like Germany and China, which have room for manoeuvre but not the political will. In the event that reflation measures become stronger than expected, we may consider revising up our forecasts for bond yields.

If interest rates remain low, and therefore negative for about half of European bonds, this means that we must expect disappointing returns in 2020 in the fixed-income universe, close to zero in euros, a little higher in dollars, which will not cover inflation, except in the riskier segments that we recommend. It will be possible to have satisfactory returns by accepting risk with European convertible bonds and Emerging Market bonds in local currencies.

Equity markets: let's be optimistic!

If growth in the global economy continues, even at a moderate pace, and yields in the bond universe are close to zero, capital flows into equities will continue into 2020. It's the famous ‘TINA,’ often used in the press: ‘Their Is No Alternative.’ Many of our positive recommendations for 2020 are in equity markets.

But let us not dream about return expectations, because they will obviously not be as good as in 2019! In our view, the stock markets will appreciate by the same degree as earnings plus dividends, making a total of +5% for mature markets and +7% for Emerging Markets. These are moderate targets in absolute terms, but very acceptable in view of interest rates which are close to zero. Long-term dividend growth is a key supporting factor for stock markets that are starting their 11th year of gains in the United States, the longest bull market in history.

With this in mind, we favour the eurozone, the US, the UK and the Emerging Markets. There is a window of opportunity for the ‘value’ versus ‘growth’ segment, and for small- and mid-cap companies. In terms of sectors, we highlight health care and financials globally, technology and building materials, in Europe in particular.

Diversify our bets

We are fully aware that our recommendations for 2020 carry risks. However, volatility is low today, but it will not always remain so. Therefore, it is important to diversify bets as much as possible. Within stock markets, this means diversifying across countries, currencies, but also sectors, themes and styles.

In addition, it is necessary to have a pocket of investments that are as decorrelated as possible from the stock markets.  That's why we like gold.  We also have a preference for alternative funds, including Global-Macro and Long/Short equity. Real estate is also a good diversification tool.

The hardest task will be to benefit from periods of rising volatility to reinforce positions in risky assets. Experience shows that it is easier to say/write than to do.

No change this month (regions, sectors and styles)

Last month we became buyers of the UK equity market and Emerging Markets. The UK market has underperformed for the past three years, due to tensions over Brexit and the risk of an exit without an agreement, which could accelerate a recession. This risk is diminishing, even though the elections on 12 December still cast a doubt over whether a clear parliamentary majority will be obtained.  Nevertheless, the discount to UK shares is likely to fall, especially for the domestic part of the stock market (FTSE 250). On the large caps index, the substantial weighting of financials and building materials (sectors on which we are positive) and the 5% dividend yield provide a significant cushion.

In Emerging Markets, the underperformance of recent quarters is likely to reverse as the overall risk diminishes. The growth environment is becoming favourable for Emerging Markets, where economic growth has traditionally accelerated more than that of mature economies. In addition, central banks remain dovish thanks to the slowdown in inflation, US bond yields will remain low (including at the long end of the curve) and the dollar is likely to remain at around current levels. Our favourite three countries in Asia remain: India (rapid economic growth, slowing inflation and above all structural reforms implemented by the Modi government), South Korea (weight of the technology sector, accommodative monetary policy) and Singapore (high and solid dividend).

We remain positive on the US and eurozone stock markets, with no change to our arguments.

In terms of sectors, we have made several adjustments to take on more risk: we are neutral on building materials and positive on European technology, US financials and insurance in both Europe and the United States. The same applies to building materials in Europe (positive instead of neutral). Finally, we have moved to neutral on listed real estate as the performance of this defensive sector has been excellent in recent years. We reiterate that we are no longer differentiating between this sector in Europe and the United Kingdom.

Style-wise, we now prefer ‘value’ to growth, and small- and mid-cap to large caps.

Bonds and Credit: No change to our recommendations

There is no change to our long-term interest rate targets, i.e. 1.75% for the 10-year Treasury bond and -0.50% for the Bund.

Despite the recent steepening across the whole US yield curve (there is now a spread of 20bp between the 2-year and 10-year bonds, while this curve briefly inverted during the summer) we continue to like short maturities in dollars that still offer an attractive risk/return ratio, only for dollar holders. The current level of the 2-year rate means that the carry is quite attractive for short durations.

We still see some opportunities in Investment Grade Corporate bonds. Last month, we adjusted our duration recommendation on European and US credit to neutral against the benchmark, instead of a lower duration previously, as bond yields are not far from our targets (at unchanged spreads). Furthermore, with the ECB resuming its purchases of European Corporate bonds, we have extended our positive recommendation to BBB-rated bonds.

We remain neutral on High Yield Corporate bonds in euros and dollars. No change.

We remain positive on European convertible bonds in line with our overall optimism on equities, as the equity component is the main driver of the current performance of convertibles, with interest rates being so low. With a few large issues in recent months, the European convertible bonds market has regained some liquidity.

In the High Yield (HY) segment, US spreads have remained low. It seems too early for us to change our recommendation on euro HY as nominal rates and risk premiums remain low, not compensating enough for the risk taken with these investments, in our view.

We remain neutral on Emerging Marketing Sovereign hard currency bonds (sensitive to the dollar and US rates, significant weight in the indices of Turkey, Argentina and Venezuela, three countries we are not comfortable with). We are positive on Emerging Market Corporate bonds in hard currencies;  in local currencies, we are positive on both Sovereign and Corporate bonds, which have a cushion thanks to the yield (close to 5%) they offer. Several central banks are likely to continue to lower their official rates, which will be supportive for these Emerging Market bonds in local currencies. Emerging Market currencies offer upside potential, but are still very volatile. The recent rebound has been substantial, largely offsetting the poor performance in 2018. The movement is not over as the Fed remains dovish.

Currency markets: no change

We are still convinced that the dollar is likely to weaken against the euro in the long term, for three reasons: i) the Fed's rate cuts, we are still expecting two rate cuts of 25bp in 2020, ii) the twin deficits (fiscal and trade) in the US and iii) the dollar is already overvalued against its purchasing power parity, at 1.28 for €1 (source: OECD).

Nevertheless, we expect a weak movement to 1.12 in 3 months and to 1.14 in 12 months.

We maintain our Sterling target in 3 and 12 months at 0.88 for €1: The Pound will bounce back if a soft Brexit materialises. We can see, without a convincing explanation, that fluctuations in the Pound's exchange rates are ultimately quite small despite a very complex political situation.

Last month we became more cautious on two Scandinavian currencies (SEK and NOK): their recent declines were contrary to the changes in growth fundamentals, inflation and the interest rate outlook. But in view of the strong market movement that is difficult to understand, we are no longer buyers of these currencies, but neither are we sellers.

Commodities: we are positive on gold and remain neutral on oil; no change

Fundamentally, gold remains attractive, in our view. The virtues of diversification in portfolios are still relevant in a context of high political uncertainty. Another major supporting factor will be the risk of rising inflation, especially in the United States. Our forecast range is unchanged at $1400-1600 per ounce over the next 12 months. We note that gold is consolidating at around $1450 with no great volatility in this more buoyant environment for risky assets. Fundamentals for the yellow metal are very strong.

We moved to neutral on oil in May. We maintain our core idea and therefore our neutral recommendation; the oil market will rebalance with production management by the extended OPEC, and with US shale oil production generally unprofitable when the price is too low. Slowing demand growth in the Emerging Marketing world is limiting potential price rises. Hence, we think oil will stay within our $60-70 range. This is exactly what happened in September/October after the destruction of a significant part of Saudi production capacity; just after the attack, prices rose sharply and then returned to our forecast range with the gradual recovery in production.

Real Estate: we are now neutral on REITs in Europe including in the UK. Valuations have risen with the excellent stock market performance of recent quarters. This sector pays dividends in the region of 4%, with income (at worst) stable, so that it can maintain its dividends without a problem. That said, REITs will struggle to outperform the market in a more buoyant global environment.

Alternative Investments (unchanged)

New opportunities in the Global Macro and Long/Short Equity segments will arise thanks to the expected return of inflation, structural changes in technology and the ongoing rebound in volatility. We remain positive on the Long/Short Equity and Global Macro segments.