MiViews Q4 2017: Should I stay or should I go?

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– The global growth picture remains strong, with the world economy growing at the firmest rate since its recovery in 2011

– Inflation pressures are gaining momentum in spite of tighter monetary policy from Central Banks

– Market stress is on the rise and could start to assert its influence over global markets once more

Overview

Performance across asset classes has been strong during the last quarter, with our long-held growth and inflation themes coming into fruition.

While we expect global growth to remain strong, there are two themes on the horizon for investors to consider. Firstly, inflation pressures are finally starting to gain momentum and, importantly, Central Banks are taking notice. Secondly, we believe market stress is poised to return as sensitivity to geopolitical risk, changing monetary policy and other sources of risk aversion is likely to increase.

 

Dynamic asset allocation

Against today’s backdrop of stable growth and rising inflation, our asset allocation maintains a positive stance regarding Developed and Emerging Markets Equities, as well as favouring long Inflation-Linked Breakevens and Commodities.

To provide further protection against any sudden spikes in risk aversion, we have strengthened our hedges by initiating a long Japanese yen versus South Korean won position and actively managing our cash position around scheduled events which have the potential to create stock market volatility.

Commodities

Chart 1: Unigestion’s world growth nowcasters

Chart 1-Unigestion world growth nowcasters

Source: Unigestion, September 2017. For more on nowcasters, see ‘Introduction to Unigestion’s nowcaster indicators’ on our website.

Chart 2: Unigestion’s world inflation nowcaster

Source: Unigestion, September 2017.

 

Growth is here to stay, for now

As we go into the fourth quarter, the global growth picture remains strong, with the world economy growing at the firmest rate since its recovery in 2011. This strength is supported by Unigestion’s proprietary world growth nowcaster – a contraction of “now” and ’’forecasting” used to indicate recessions – which points to steady growth globally.

Growth continues to be led by developed markets (DM). One of the features behind its strength is the improvement in corporate investment – a welcome trend in today’s environment. As highlighted in chart 3, the “investment” component of our growth nowcaster has considerably increased to reach levels last seen in 2003, albeit not quite as high as the peaks recorded during the investment cycle of the late 1990s.

Chart 3: The level of investment is increasing across developed economies

Chart 3-The level of investment is increasing across developed economies

Note: average of the “investment” component across 6 growth nowcasters: United States, Eurozone, United Kingdom, Japan, Canada and Switzerland. Source: Bloomberg, Unigestion’s calculations, September 2017

 

While Emerging Markets (EM) appear to have some catching up to do, our EM growth nowcaster has been evolving gradually since 2015 and now suggests EMs should enjoy a much better growth situation than over the past five years.

One indicator behind this recovery in EM growth is the rise of the emerging consumer. Chart 4 shows that consumption across EM countries has risen significantly over the past two years, particularly in Latin America. Moreover, consumer sentiment surveys are also pointing towards increased wealth and larger spending from the emerging consumer. This trend is likely to lower the risk of recession further, while sustaining the demand for commodities.

Chart 4: EM consumption is on the rise

Chart 4-EM consumption is on the rise

Source: Bloomberg, September 2017. Unigestion’s calculations.

 

While the emerging consumer story should continue to drive growth across the region, the pace of this growth is likely to differ across EM economies. Specifically, India and China have shown signs of slower growth recently.

Chart 5: China and India are growing at a slower pace

Chart 5-China and India are growing at a slower pace

Source: Bloomberg, September 2017. Unigestion’s calculations.

 

The cooling of China’s housing market has been a key contributor to its slowdown. However, while the downward trend of China’s property market is expected to continue, we do not believe the situation is as severe as seen in 2015.

With regards to India, its export sector has shown signs of slowing down, as has the rest of Asia’s external trade. Yet, in our view this remains a minor risk for the time being.

 

All aboard the reflation train

Inflation pressures continue to remain steady in spite of tighter monetary policy from Central Banks. However, this backdrop could finally be changing. Our inflation nowcaster’s diffusion index – which measures the percentage of improving inflation data – has started to increase for the first time since April this year. We believe this is a significant development and, in our view, there are three key factors behind it:

  • The Bloomberg commodity index rose by 8% between mid-June and mid-September, reflecting both the consequence of a weaker US dollar and stronger demand, especially for oil. This uptrend in commodity prices benefitted our overweight in inflation-related assets over the quarter.
  • The US dollar has had a significant influence on inflation over the past three years: a rising USD in 2015 saw global growth slow down considerably; the currency’s recent decline is having the reverse effect and also increasing import prices for many economies which are tied to it.
  • The last piece of the inflation puzzle focuses on central banks – more precisely the Federal Reserve (Fed) and the European Central Bank (ECB). What we have learned from the first half of this year is that by tightening monetary policy, the Fed has managed to calm down inflation expectations.

If inflation gains momentum, we expect the Fed to act again this quarter. After its September meeting, the Fed reasserted its will to enforce tighter monetary policy, however the broader market remains unconvinced (see chart 6).

Chart 6: Market has low expectations of the future Fed’s target rate

Chart 6-Market has low expectations of the future Fed’s target rate

Source: Bloomberg, Unigestion’s calculations, September 2017.

 

We believe both the Fed and the ECB have become increasingly hawkish in tone: they are preparing to slow down the easy money that has been significantly benefiting markets. While this is not exactly new news, it must be recognised as a major risk: the 2013 tapering turbulence left market participants with more than vivid memories.

While the Fed’s path remains pretty clear; the ECB’s is not. Mario Draghi is widely acknowledged to be considering slowing down quantitative easing (QE), but in our view the impact of this year’s 15% rise in the euro on both European growth and inflation is unknown and could create a reason to further delay the end of European QE.

Chart 7: Central banks are becoming increasingly hawkish

Federal Reserve

Chart 7: Central banks are becoming increasingly hawkish

European Central Bank

European Central Bank

Source: Bloomberg, Unigestion’s calculations, September 2017. Reading notes: The central banks’ “heartbeat” is a proprietary tool developed to track the tone of monetary policy members. A score of 1 (hawkish), -1 (dovish) or 0 (mixed) is attributed to each public declaration and aggregated into an indicator. The assessment of the hawkishness or dovishness of the declaration is discretionary.

 

Managing market stress

The most significant change we’ve seen this quarter is that, after 18 months of decline, our market stress nowcaster has started to rise. This leads us to believe market stress could start to assert its influence over global markets once more.

There are a number of factors behind this upturn in market stress. Primarily, it’s a secular trend. Since the global financial crisis in 2008, the frequency of volatility episodes – such as markets shocks and large-scale events – has dramatically increased, resulting in a higher number of periods of severe, short-lived losses. The evolution of financial markets and the demise of primary dealers since 2008 have both played an important role.

Another major cyclical driver has been the overall tighter liquidity environment – a reflection of Central Banks’ monetary easing policies.

Finally, the fact that global equity markets have reached very high levels this year will inevitability increase market sensitivity to any market shocks – EM equities have posted a 28% return year-to-date, while the total return for DM stocks is 16.5% (Source: Bloomberg, September 2017).

While market shocks are one thing, the market’s reaction to such events is an important issue to consider. Our overall positioning on equities and bonds is net long, illustrating our faith in the current outlook for growth.

Chart 8: Unigestion market stress nowcaster

Chart 8-Unigestion market stress nowcaster

Source: Bloomberg, Unigestion’s calculations.  September 2017.

 

However, our main response to this change in our market stress nowcaster is not to predict which event will trigger a volatility episode, but to consider what we can do in advance to protect our main allocation positions: being long growth and inflation-related assets.

We believe there are two types of stress triggers: scheduled and unscheduled events and both are mainly related to either political or monetary policy risk. As the name suggests, a scheduled event is something that is planned, such as an election; while an unscheduled event is something that is not expected, i.e. an escalation in geopolitical tensions. For both types of events, we recommend actively using hedges in order to shield returns from potential downside risks.

Chart 9 represents examples of two recent scheduled events and illustrate a striking pattern of how “beta” tends to become negative as an event approaches and then sharply recovers once the event has past.

Chart 9: Beta performance around political risk-related events

Performances around the Brexit vote

Performances around the Brexit vote

Performances around the US election

Performances around the US election

Source: Bloomberg, Unigestion’s calculations.  September 2017.

 

Our approach to such events is to raise our cash positioning ahead of the event and then using this to quickly re-enter the market once the perceived danger has past. We also believe that maintaining a high level of asset diversification is advantageous when navigating such challenging environments.

When an event date is unscheduled, beta can no longer be efficiently used and therefore we need to consider other hedging strategies. In the current environment, especially given our views on inflation, we are reluctant to employ bonds – a traditionally lower risk asset – as a basis to provide protection from this type of market stress. However, in our view, the forex market offers some interesting hedging opportunities. Chart 10 illustrates the strong performance of the yen versus various currencies during periods of market stress: overall our analysis suggests that such a trade would deliver an equivalent Sharpe ratio to bonds with an equivalent level of liquidity.

For example, in a bid to protect the portfolio against any further escalation in geopolitical tensions with North Korea, we have implemented a long Japanese yen and short Korean won position. In our view, forex markets can help create a very precise offering of hedges.

Chart 10: JPY’s performance across periods of negative S&P500 returns (2014-2017)

Chart 13-JPY’s performance across periods of negative S&P500 returns

Source: Bloomberg, Unigestion’s calculations. Past performance is not a guide to future performance.  September 2017.

Conclusion

Growth and inflation continue to be the core drivers of our asset allocation. However, the most significant change highlighted by our nowcasters this quarter is the potential return of stress-related volatility, with markets expected to show more sensitivity to bad news going forward. Given downside protection is one of our central tenets, we have sought to protect our main allocation positions as follows: dynamically adjusting our cash position ahead of any scheduled market-stress inducing events to limit exposure to beta and utilising the forex and option markets to find interesting hedging opportunities.

 

Important information

This document is addressed to professional investors only, as described in the MiFID directive and has therefore not been adapted to retail clients. It is a promotional statement of our investment philosophy and services. It constitutes neither investment advice nor an offer or solicitation to subscribe in the strategies or in the investment vehicles it refers to. Some of the investment strategies described or alluded to herein may be construed as high risk and not readily realisable investments, which may experience substantial and sudden losses including total loss of investment. These are not suitable for all types of investors. The views expressed in this document do not purport to be a complete description of the securities, markets and developments referred to in it. To the extent that this report contains statements about the future, such statements are forward-looking and subject to a number of risks and uncertainties, including, but not limited to, the impact of competitive products, market acceptance risks and other risks. Data and graphical information herein are for information only. No separate verification has been made as to the accuracy or completeness of these data which may have been derived from third party sources, such as fund managers, administrators, custodians and other third party sources. As a result, no representation or warranty, express or implied, is or will be made by Unigestion as regards the information contained herein and no responsibility or liability is or will be accepted. All information provided here is subject to change without notice. It should only be considered current as of the date of publication without regard to the date on which you may access the information. Past performance is not a guide to future performance. You should remember that the value of investments and the income from them may fall as well as rise and are not guaranteed. Rates of exchange may cause the value of investments to go up or down. An investment with Unigestion, like all investments, contains risks, including total loss for the investor.

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