Il y a du changement

Markets have performed well this year despite all the uncertainties. A clearing of some of those is possible in the weeks ahead (possible I said, not probable). If that does happen, risk is likely to rally. And if it does, rates might go higher as curves steepen. At the same time, risk is not cheap. It all adds up to a very difficult investment environment for the foreseeable future. The good thing is, policy is supportive and beta is performing. The challenge for all investors is what combination of assets and risk profiles works best for them when there are likely to be continued challenges in understanding how the environment unfolds.

Change

I have been lucky enough to have had my role at AXA Investment Managers enhanced to allow me to also represent our active equity and multi-asset teams and strategies as well as continuing to be an ambassador for fixed income. As such this will be the last of these Insights that focusses purely on the bond market.  As long-time readers will know, I don’t need much encouragement to stray into other topics and have always been a big advocate of understanding the relative values of different asset classes and how they can be, and should be, combined in order to achieve different outcomes, meet different risk budgets and address different macro-economic circumstances.

I work for a firm that manages a wide range of investment strategies and solutions for a wide range of clients in numerous countries. The common themes are providing solutions and strategies that meet client needs, understanding how markets evolve and remembering to be humble when faced with the unpredictability of economic policies, regulation, a changing competitive environment and the ability to execute in a timely and efficient manner. I hope my commentaries and my support for our fund managers in terms of providing the framework for them to execute good investment ideas can be of benefit to a broader range of clients, colleagues and readers in the years to come.

Deal?

A big week for me then but an even bigger week for the future of the UK and Europe. As I write the screens are alive with comments coming out of meetings between UK and EU officials and markets have fastened on to an improved chance of there being a deal before next week’s EU summit.

It’s been the usual market response – sterling higher, gilts lower and mid-cap equities roaring ahead of the FTSE100. However, by the time you are reading this, things could have changed again given the obvious difficulties in satisfying all parties – the UK government, the EU, the various factions within the Conservative Party, the Democratic Unionist Party, the European Research Group and so on. Not that all of these are involved in making a deal, but they will have an influence on whether any deal gets ratified, as, of course, will the Labour, the Liberal-Democratic and other parties in the British parliament.

While sterling has risen from a recent low of below $1.20 to above $1.25, I imagine that a move up to $1.30 and above will not be easy. Although, I suspect that’s how the smart leveraged money is positioned given that the slide in the pound since last March has been driven by the shortening of the odds on a no-deal with every rejection of Theresa May’s Withdrawal Agreement. The best return now would be on what has so far been the least likely outcome.   

Not near the end

Very few market participants I speak to have significant Brexit bets on. The outcome has always been too difficult to call and even if there is a deal agreed in the coming days, the implementation of that will not be smooth. Market reversals are clearly a risk even on a more positive trend.

A no-deal hard Brexit remains a possibility and that would still be the scenario with the most market impact. The longer term consequences of that for the UK economy and the policy environment are also the most uncertain. Such an outcome could be met with a loosening of both monetary and fiscal policy with some potential steepening of the gilt yield curve but a more ambiguous trading direction for the currency. UK credit and equity markets could react badly, given the potentially negative shock to the economy, but the longer term outlook would depend on how effective the policy response would be and what level of political volatility resulted. It would be hard to call any market movements if there was a no-deal (however difficult parliament appears to have made that outcome) followed by a general election that resulted in a hung parliament. It’s hard to judge what foreign portfolio flows would do but that outcome would not appear to be the most conducive to new marginal foreign capital flows into the UK. At least not for some time.

Trade and Trump

The generally positive tone to markets at the time of writing was also a reflection of some more positive signals on the US and China trade front. One could argue that it is becoming even harder to second guess President Trump based on his recent Twitter activity, but a more sober assessment of where we are in the political cycle tends to err on the side of believing some deal will be done. Whether that will be substantial enough to mean a reversal of tariffs on Chinese products or merely the removal of the threat to extend and increase them remains to be seen. It is likely that there would be a positive announcement effect which would be good for risk assets going into the final couple of months of the year. However, for a more medium term view we would need to see whether the damage done to the global manufacturing sector could be reversed at all.

As I wrote last week, the US ISM index has joined the inversion of the yield curve in providing a signal of a potential US recession. These signals are not enough in themselves but in the past US recessions have coincided with a significant drop in the ISM index and an inverted yields curve. Offsetting that is a still strong labour market in the US and the fact that the Federal Reserve (Fed) has started to ease and looks likely to continue with the rate cuts at the end of this month.

Be careful not to get carried away 

Before the green light flashes “go bulls”, we have to think about what the climate looks like post any deflation of the Brexit or protectionist risks. As I say above, a deal over the next week is not a guaranteed mutually acceptable agreement on the long-term economic relationship between the UK and Europe. Being outside of the Single Market and Customs Union is a significant change in the operating environment for UK plc and with that comes uncertainties at the macro and corporate levels.

Same with the US and China. If Trump does a deal with Beijing to help him in the 2020 election and he wins, might he then turn his attention to Europe? The last thing Europe wants is a protectionist punch in the face from the US. Beyond all of that there is the structural backdrop of low inflation and the distortions to capital markets caused by quantitative easing. What happens to China, even with a deal with the US, when it is going through a long-term re-balancing of its economy to a much slower, more domestically driven model? Will Japan ever show stronger nominal GDP growth when its demographics work against it? And there will still be geo-political risks with Hong Kong, the unpredictable power games of Putin, middle east instability and North Korea seemingly intent on going against the spirit of recent discussions on nuclear weapons with the US. 

Where is value?

If all of this wasn’t enough, valuations across asset classes are not that attractive. Bond yields remain close to all-time lows, credit spreads are hardly pricing in corporate distress and equity multiples have been cheaper. Even if all the risks disappeared and the outlook was a lot less uncertain, it is not as if investors are going to be faced with typical post-bear market levels in stocks and credit. Indeed, we would have to contemplate higher interest rates which would perhaps inhibit the performance of risk assets. It would be ironic if the market reaction to clearing of policy and geo-political uncertainties was higher rates and a more typical financial-squeeze led recession. It seems a lot of investors are sitting on cash and it is not clear what tempts them back into the market unless it is for a short-term rally based on a Brexit and trade deal. Clutching at straws are we? In fixed income, yield levels are the biggest issue (the German sovereign curve is still mostly negative, the European high yield index has a yield to worst of just 3.5% for an average BB- rating) and many investors find it hard to get their head around the fact that long-dated government bond yields could again fall to the lows reached in August.

Sensible long-term approach

So diversification and opportunism remain key to a successful investment strategy. Humility is important because our world is hard to understand and is unpredictable.

We can all argue whether the US curve should be inverted or not, or whether rates are too low, or that inflation break-evens are worthless, or that equity markets are not pricing in a more pronounced slowdown in earnings growth than that reflected by consensus forecasts. But betting on binary outcomes is not always the most efficient investment strategy. Building portfolios that combines risk premiums, have an exposure to cash-flow and provide an appropriate level of liquidity is a better long-term strategy. In my enhanced role I hope I can help investors achieve this.

Red Devils (cry)

I will still have a word or two about sport and other interests. As you can imagine, I am finding it hard to say much about the fortunes of Manchester United at the moment. There are plenty of people already doing that (it’s the biggest club in the world, what do you expect?). I conceded that it’s a sorry state of affairs. But I am not one calling for the manager’s head – that has not proved to be a successful way of going about things in recent years. I am more inclined to be patient. It took Liverpool a long-time to get back to the top, it took a lot of money for Manchester City to get to the top and it has taken a special culture to allow Leicester to win the league and to be again challenging for a top four place.

United has to rebuild, on and off the field. It’s just hard as a fan to watch a performance like the one against Newcastle last week. What’s more, it’s Liverpool up next. Ah well, it’s only a game.

               

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