October Investment Strategy - Re-balance sheet policy

Key points

  • With some progress on the trade war and Brexit, some tail risks are receding. But we are far from resolution.
  • The news flow is thus not positive enough to stop the gentle slide in economic data, with global weakness no longer contained to manufacturing.
  • For now, the US Federal Reserve still has some space to move, but we think we reached “peak monetary activism” in Europe in September.
  • Investor confidence and valuations are likely to prevent any sustained rally in risk assets into year-end.
  • Clarity on trade and Brexit could see sharp risk rallies. Credit markets generally provide the best opportunities.

It’s not over until it’s over

We have seen progress on global risks in recent weeks. A partial trade agreement between the US and China is being negotiated, to be finalised at a meeting between US President Donald Trump and Chinese President Xi Jinping on 16 November. A last-minute Brexit deal was struck between the UK and the EU.

Still, the trade war has likely gained nothing more than respite for now. Proper resolution – including a full roll-back of the tariff hikes – is still far away. There are also concerns over a pivoting of the trade war towards the EU, with the dispute over aircraft another illustration of the underlying tension. The US presidential impeachment saga may add to the wait-and-see attitude to investment in the US corporate world, now that less middle of-the-road Democrats are taking the lead ahead of the presidential primary elections.

What initially promised to be a swift endorsement of the Brexit agreement was delayed by the British parliament. Investors can now start focusing on the content of the deal – instead of rejoicing in its mere existence – but they will likely discover that even if the Commons ultimately supports it, the Brexit saga will be far from over. A gruelling negotiation is ahead of us on the EU and UK free trade agreement, which is expected to define the long-term relationship after the expiry of the transition period at the end of 2020.

In a nutshell, while some tail risks are receding – such as further trade war escalation or a no-deal Brexit – uncertainty is not disappearing. While this avoids catastrophe, the skies are not clear – at least not enough to stop the slide in data flow. Weakness is no longer contained in the manufacturing sector, but now spreading to services, in the US and Europe. There is no smoking gun indicating a full-on transmission to the labour market – which would affect consumer spending, now the only properly functioning engine in the global economy. But without a proper confidence boost, this would normally be the next step. The global economy is in a race against time. In a matter of months, the downturn will have reached escape velocity and will become self-reinforcing.

ECB: new boss, old problems

In the US we can take comfort in some half-decent monetary policy actions to cushion the blow. We expect the Federal Open Market Committee to cut rates at its next meeting on 30 October, with probably another cut in December. Conversely, when looking at the European Central Bank (ECB), we find it hard to see what more it could do in the next few months, unless the situation turned truly catastrophic.

Mario Draghi will preside over his last Governing Council meeting as ECB President in October. His legacy as the “saviour of the euro area” from 2012 will endure. It is a pity September’s move has given way to such controversy. With the dissenters in the Council showing no signs of backing down – and a lack of confidence in monetary policy’s ability to provide meaningful support – we think we reached peak monetary activism in the euro area in September. Christine Lagarde is going to start her tenure with a strategic review which is likely to trigger some tricky discussions in the Council and in practice justify inaction while it is debating.

In the meantime, the ECB will make €20bn of purchases per month. Banks may use the entirety of their allowance in the next Targeted Longer-term Refinancing Operations (TLTROs), though this would entail a significant change of stance after the disappointing take-up in September. If so, the overall growth rate of the ECB’s balance sheet – a good proxy for the monetary stance in times of unconventional policy – could reach around 6% year-on-year (yoy) by the end of 2020. This would be a slower pace than in 2012 or in 2016. Even with very controversial decisions, President Draghi could not trigger the same quantum of monetary stimulus. Christine Lagarde’s tenure could start under better auspices.

Investment outlook to remain frustrated

For investors, the last months of 2019 are likely to be as frustrating as those preceding. Ongoing uncertainties on the policy and political fronts, together with the steady erosion of growth, do not provide a high level of investor confidence. Yet low interest rates and negative bond yields continue to punish a “safety-first” investment strategy. During the summer, the classic flight-to-quality trade of long duration rewarded investors but now, with yields still in the lower half of the year’s range, another “get out of jail free” card is unlikely. The current prognosis of the world economy is not great and if tail risks were to materialise it could get worse – but investors need to look beyond the clear and present dangers. There appears more chance of fiscal stimulus in a number of countries, while the Fed should deliver further easing. In the bond market that will mean a bias towards curves re-steepening – a signal of a more positive outlook.

That’s not to say we are bullish on credit and equities right now. Valuations are not attractive. Markets have not gone through a recessionary cheapening – a risk that will remain for months to come. There will be relief rallies if a trade deal is seen as substantive and if UK Prime Minister Boris Johnson gets his Brexit, but a more significant rally in risk needs positive feedback from markets to the real economy. That will take some time – and it will need validation in earnings forecasts and in the flow of economic data.

So, the outlook will remain frustrating. Income from bond markets is hard to come by and with yields and spreads where they are, we don’t envisage much in the way of capital gains. Short duration strategies in high yield and some exposure to less liquid credit assets should be rewarding when the credit environment remains solid. Recently-announced earnings in the financial sector also support our positive stance on bank debt. For equities though, the headwind of lower growth remains key.

As for Brexit, the volatility of the political process is likely to be reflected in financial markets. The sterling exchange rate rallied sharply when the UK/EU deal was announced, but new challenges to the Brexit process are likely to reverse the rally somewhat. Long-term sterling bulls need to believe that the UK government can see through the deal and forge a clear path towards a new trade agreement with Europe.

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