Multi-asset investments views - August 2019: Extreme pricing
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With heightened growth concerns and trade war risks still lingering, market pricing has reached very aggressive levels which creates investment opportunities.
Firstly, markets expect the Fed to cut rates by 100bps over the next 12 months, more than during similar episodes in 1995 and 1998 when the Fed eased proactively to prevent any material growth deceleration. We think it is too extreme. Admittedly, Fed Chair Powell strongly signaled a rate cut is coming which was well summarized by Fed permanent voter Williams who said: "It's better to take preventive measures than to wait for disaster to unfold". However, the current economic context doesn’t warrant more than 2 cuts in our view. Indeed, recent incoming data has surprised to the upside (e.g. US June industrial production, retail sales, inflation and labor market data), while service sector surveys show limited spillover from the manufacturing sector weakness so far, tempering downside risk and possibly hinting at a bottoming of the recent growth downshift. Moreover, consensus building is important in Fed decision making, and several FOMC members are not convinced of the need for very aggressive insurance measures to lift inflation.
Within equities, this extreme market pessimism on growth is reflected in the massive dispersion in valuations multiples, with the relative valuations of Value versus Growth stocks or Cyclicals versus Defensives at recession level. This valuation gap is the strongest in Europe. However, business surveys point toward global growth at or slightly below potential, and the combination of global policy easing, supportive credit conditions, and solid consumer spending gains suggest that the global expansion should not break. Therefore, we expect the wide valuation gap between expensive defensive bond proxies and cheap cyclicals to start to correct when it becomes apparent that the global expansion is not over. In this context, we have decided to introduce a cyclical tilt in our Euro equity exposure.
Pricing is also extreme regarding inflation. The bond market has taken a clear view that not only has Europe's economic outlook become more comparable to Japan's but, with the bund yield now drifting below the JGB yield, it could be worse. As a result, inflation breakeven have fallen to ultra-low-level hovering around all-time lows (cf. chart below). We disagree with this extreme pessimism as, by contrast to Japan in the 90’s and 2000’s, wage growth is rising steadily in Europe (in both nominal and real terms). True, inflation is unlikely to reach ECB’s target anytime soon, but it should at least prevent realized inflation to fall further and help inflation expectations to normalize somewhat from ultra-depressed level. Therefore, we have implemented a long position on Eurozone inflation breakeven in our portfolios.
Inflation expectations have fallen to all-time lows
Source: Bloomberg, AXA IM Research
Our key convictions:
- We remain prudent on US equities given trade war risks and aggressive Fed pricing; we have introduced a cyclical tilt in our Euro equity exposure as market pessimism on growth is extreme
- We remain positive on emerging debt and US High Yield as a more dovish Fed is supportive for carry positions
- We are more constructive on Eurozone inflation breakeven as market pricing seems too pessimistic
- Underweight US equities
- Cyclical tilt in our Euro equity exposure
- Positive EM debt and US High Yield
- Positive Eurozone inflation breakeven
- Positive NOK versus AUD and CHF
- Long equity call options delta hedged to protect the portfolios where possible
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