In an environment becoming naturally more volatile the key challenge of investors is how to build resilient portfolios and exploit opportunities to meet their shortand long-term objectives.

Introducing the next roundtable, Pascal Blanqué outlined his takeaways from the previous discussions. The first is that global growth may no longer be based on global trade, but rather on regional or domestic trade. Another aspect is that international diversification failed in the last three decades because of an important correlation to global trade. This could now change, with diversification growing. And the third – and a reason to be optimistic – is that productivity will accelerate again, although this is not yet grounded in data.

Asked what the internal debate at Amundi is, Mr. Blanqué replied that, apart from being worried about the era of diminishing returns, the discussion is about where we are in the cycle. Are we close to the end or in the early stages, and will we see a classic reversion to the mean of valuation?

Other topics are that benchmarks have started to flatten, how to preserve capital, what price to pay for flexibility, and how ESG is beginning to be seen as pool of risk factors.

Mr. Blanqué proved concerned about the scarcity of opportunities, recommending holding cash to redeploy during the cycle, which is what Amundi is doing in emerging markets.

THE US MARKET – LIKELY RATE RISES AND EXCESS CREDIT

Ken Taubes joined in with comments on the US market. He is concerned that the Fed will have to be restrictive to slow down the US economy to the growth trend of below 2%, which the market is underestimating. This probably means further rate rises and reductions of the balance sheet, which could lead to an inverted yield curve and a growing shortage of dollars. This is a problem for emerging countries with large dollar debts. So far, the US has been insulated, but he is considering raising the quality of the fixed income portfolio and may look at equities again. Being short duration is not advisable at present in the US market.

Comparing debt and equity markets, Mr. Taubes favoured the latter. Most of the market is not overheated on the equity side, and equity is cheaper than fixed income. Some of the excesses are in the credit market, not in mortgages or banks, but in corporate credit, particularly investment grade credit with high leveraging. The investment grade corporate index has dramatically increased, bank loans have been underwritten with poor covenants, and CLOs are back. Furthermore, a lot of the lending from the last cycle has moved off the books of the Fed, to private debt pools for example. So it is a good idea to upgrade the quality of the portfolio, he posited. Some high-quality mortgages are attractive,and even some Treasuries.

ARE EMERGING MARKETS VULNERABLE?

In a crisis scenario, the resilience of emerging market economies always surfaces. During the 2008 financial crisis, and during US tapering, emerging markets were hurt significantly. Where do we stand now? Are they as vulnerable at present?
The situation is better now than 2008. 
• All vulnerability indexes are more solid. 
• Inflation in some cases is below the inflation target, giving leeway to monetary policy. 
• Growth is solid and several growth engines are at work. 
• Apart from trade war risk, all risk factors are more local (i.e. Argentina and Turkey) than global. 

However, there are at least three clearly identified threats. 
• A trade war would impact first Europe and emerging markets, before reaching the US. 
• A very strong dollar would impact emerging markets first. 
• Much higher US rates would impact emerging markets first, followed by US corporates. 

EUROPEAN AND EMERGING MARKETS PATIENCE IN A TIME OF TRANSITION AND VOLATILITY

Turning to European markets, Eric Brard counselled patience and self-control since we are in a transition with the end of quantitative easing and increasing political and trade risks. To perform well you have to avoid traps in the market. One of these would be to take advantage of opportunities in Italy or to “find shelter” in the German Bund market.

On whether to buy emerging market assets, Yerlan Syzdykov said that it is too early; there will be better points of entry in the future. The current volatility in emerging markets started with the strengthening of the dollar, so we have to see it stabilise first. This could happen if growth in the US slows or the gap between US and European growth narrows. In addition, rising protectionism could lower growth in emerging markets, and populism is rising in countries such as Mexico and Brazil.

Asked which currencies and types of credit are attractive in emerging markets, he prefers hard currencies over local currencies and corporate credit over sovereign credit. On ESG investing he said that the “bang for the buck” is actually much higher in the developing world, especially the governance part. This should be done on an engagement rather than an exclusion basis, especially since in emerging world standards on ESG issues are different or not well developed.

Commenting on global investment perspectives Mr. Brard said that a key consideration is rising interest rates and their impact on fixed income portfolios, which has to be addressed on a case-by-case basis. He remained cautious on interest rate exposure, but not in every segment and not in every country. Illiquid assets also have advantages, paradoxically even to manage liquidity. And currencies, of which $5 trillion are traded every day, should not be ignored in managing fixed income portfolios.

« We are in a situation where we need to avoid too much portfolio concentration on a specific market segment to be able to maintain our room for manoeuvre for future opportunities. »

Eric Brard

 

« We are in a situation where we need to avoid too much portfolio concentration on a specific market segment to be able to maintain our room for manoeuvre for future opportunities. »

Eric Brard

 

IS THE BOND MARKET AT RISK?

Globally the excess liquidity provided by central banks is not raising the prices of goods and services but of financial assets. There is no price inflation, but asset inflation. Overall, interest rates are unusually low due to ultra-expansionary monetary policies and QE, excess liquidity in central banks, and lower market liquidity. Higher short-term rates and a scarcity of risk free assets leads to bond yields at sustainable low levels and flat yield curves. In Europe, the bond market is at risk because the price does not reflect the effective risk and because of the gap with the fundamental value (around 100 basis points).

In the US it is different; bond yields are in line with the fundamentals. The question is whether the bond market can finance the twin deficits. Is the risk-free asset role of US public debt and the global demand for US treasuries sufficient to finance them? US Treasuries are the largest global risk-free asset, thanks to the liquidity of their market and the ability of the US government to remain solvent. During crises and recessions, investors rush to this asset class, which lowers US equilibrium interest rates and leads to an appreciation of the dollar.

However, historically it is easy to find periods when the risk-free asset role of US public debt has been insufficient. Sometimes it is insufficient to finance the US public deficit, which normally leads to a rise in US bond yields. This occurred in 1983-84, 1990-91, 2013-2014, and 2017-2018. Sometimes it is insufficient to finance the US external deficit, which normally leads to a deprciation of the dollar, as in 1985-87 and 2004-2008.

At present, the expansionary fiscal and tax policy of full employment should lead to both a public deficit and an external deficit in the US. Therefore the risk of interest rates rising and the dollar depreciating is growing. These risks are not yet priced into valuations.

TIME TO REDUCE RISK EXPOSURE

The moderator next turned to Matteo Germano for his views on risk allocation. He said Amundi is revisiting risk exposure and risk allocation. He started the year “risk-on”, based on fully-synchronised growth, but has been progressively reducing risk exposure in both equity and debt. He forecast an even more conservative allocation in 2019. Vincent Mortier supported his cautious view on risk, in particular in areas that have seen the highest growth. In parallel, investors should look at the yield curve and absolute levels of rates, which is the main driver for the market going forward.

Mr. Germano emphasized several idiosyncratic risks in Europe, the rising cost of hedging, and the increasing volatility of equity spreading to interest rates and foreign exchange. He recommended that clients be disciplined in identifying risks, looking at both their probability and their impact, and how the market is pricing them. The more idiosyncratic the risks are the more active you have to be, because generic hedging may not work and in some cases be too expensive.

« Be dynamic and not worried about sometimes using liquidity. It is alright to be outside of the market and wait for a price dislocation to reenter with a better opportunity. »

Matteo Germano

« Be dynamic and not worried about sometimes using liquidity. It is alright to be outside of the market and wait for a price dislocation to reenter with a better opportunity. »

Matteo Germano

PICK STRONG STOCKS IS THIS CHANGING ENVIRONMENT

On the equity part, Mr. Mortier suggested moving to market leading companies that can are more resilient and can enter the next cycle with strong positions. He believes the market will move to value, depending on where interest rates go. We have been in a bond market for 10 years, he said, with more and more indexed, quantitative, or systematic strategies driving the flows and the positioning. This has a big effect on momentum.

Secondly, the micro and macro environments are shifting and there are new elements to consider, such as tariffs and regulations. These are more complex to navigate and can have different effects depending on the country, sector, and company. Amundi will count on extensive research and analysis for picking stocks. Factor investing will play a role, he added, which has lately included long-short factors, since clients are asking for market-neutral approaches. Tools based on artificial intelligence will also help clients navigate through how factors are behaving to make better allocation choices.

Mr. Germano stated that he is looking at three investment themes. The first is “last race on risky assets” wherein there is still some profit to be made from risky assets if you are very selective based on different criteria from the past. The second is central bank synchronicity. As the quantitative easing phase ends there will be opportunities in the asynchronicity of the pace of change of policy at central banks. The third is emerging markets such as China, and possibly emerging market debt, which is increasingly fairly valued.

« Don’t be complacent, the past is not always a good predictor of the future, so do your research, ask us to help you navigate, and explore new territories. Be curious. »

Vincent Mortier

 

« Don’t be complacent, the past is not always a good predictor of the future, so do your research, ask us to help you navigate, and explore new territories. Be curious. »

Vincent Mortier

 

ECB VERSUS FED – DIFFERENT REACTION FUNCTIONS SO FAR

One of the lessons of the past two years has been that in the non-inflationary growth environment the reaction functions of the Fed and the ECB were completely different. How can we explain this asymmetry? There are five reasons:
1. The ECB only has the mission of price stability, while the Fed has several missions.
2. US companies plan to raise wages soon, while European companies will not.
3. The ECB is stuck with negative rates.
4. The ECB deals with divergence between countries, while the Fed considers the US as a whole.
5. The Fed is normalizing rates at the end of the expansion (allowing it to act later when needed), while the ECB is delaying normalisation to not curb growth at the end of expansion, which may continue in the Eurozone.

In fact, the current behavior of the ECB is based on two bets:
• First bet: the unemployment rate in the Eurozone at present is significantly higher than the structural unemployment rate. If not, the Eurozone’s key rate would have to be close to the neutral interest rate of 2 %-2 ½% and not zero.
• Second bet: in the Eurozone, expansionary monetary policy has a positive effect on wage growth, unit wage costs, and thus on underlying inflation. If this were not the case, the ECB would have to maintain zero interest rates with no time limit, if it wants the option of restoring inflation.

The different reaction functions of the Fed and the ECB led to higher interest rates and bond yields in the US, and lower rates and bond yields in the Eurozone. In fact, in the Eurozone more than 50% of bond universe (which includes debt from sovereigns, quasi-sovereigns, corporates and financial entities) have a yield below 0.5%, and more than 25% still have a negative yield.