2019 Scenario : The deterioration of the risk/reward ratio for assets justifies a highly selective investment approach

06/12/2018

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With no cyclic excessive production, stocking and investment observed in corporate activity so far, the economic growth cycle is expected continue in 2019. However, the end of the accommodating monetary policies of central banks and the persistence of risk factors could affect the liquidity of the markets and fuel a resurgence of volatility. This combination of conditions is an argument for adopting a selective investment strategy.

The macroeconomic environment is expected to remain favourable over the next few quarters. The central scenario of Groupama Asset Management consists in a normalization of economic activity in 2019, with a slowing of growth, forecast to be 2.5% in the United States and 1.6% in the Eurozone.

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Observers are legitimately beginning to question when the current boom in the American economic cycle will end, after a decade of positive growth. In our view, the key factor likely to provoke a recession is not the duration of the cyclic boom but excess in the overall economy. However, at this stage, we do not see any overproduction, overstocking or even over-investment in the activity of companies, which are still lagging behind demand.

Christophe Morel
Chief Economist

Household consumer spending is currently boosted by a rise in wages, which is now perceptible both in the United States (wage inflation could reach a high point at 3.5%), and in Europe, the UK and even Japan.

Although a continuation of this robust economic situation is the most probable scenario according to Groupama AM, various alternative scenarios have also been envisaged: “three situations could halt the current global economic growth: first, an escalation of trade war, causing a sudden downturn in trade; second, excessive wage growth in the United States, impacting corporate profit margins and profitability, forcing companies to apply a cyclic adjustment; or, third, a liquidity crisis caused by more marked monetary tightening”.

 

Central banks: spotlight on the non-conventional component of their policy

The third scenario would have the same origin – a significant rise in salaries – but different consequences. Companies, thanks to their “pricing power”*, would be able to react by raising their selling prices. Profit margins would therefore be preserved.
However, central banks would be forced to drastically accelerate their monetary tightening, which would put a strain on interest rates and would also result in an adjustment of risky assets and, finally, a negative wealth effect spreading from the financial economy to the real economy.

“These alternatives are not our central scenario for 2019. We remain convinced that central banks will continue to implement a policy of cautious money tightening, without taking the slightest risk with growth. Their official communications remain reassuring,” comments Christophe Morel. The markets will be particularly attentive to the non-conventional component of monetary policies. “The Fed will have to communicate effectively on its ending of the policy of balance sheet shrinking, while the challenge for the ECB will be to deliver prospects for the economy post-LTRO**, which will end in June 2019”. A third of T-LTRO has been used by the Italian banks, which will therefore normally have no further levers.
The theme of “non-conventional” policy is attractive to investors, because it is directly connected to the liquidity of the markets,” adds Christophe Morel.

 

Less liquidity, more volatility…

Concerning the financial markets, the Groupama AM team expects the asset risk/reward ratio to decline in quality due to a resurgence of volatility and a reduction in liquidity.

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The fundamental catalysts and the continuation of the macroeconomic cycle will remain favourable to higher-risk assets and will further boost the upward trend of interest rates, sustained by the progressive withdrawal of non-conventional measures by the central banks. But, at the same time, this normalization of monetary policies will reduce liquidity. The markets will be more exposed to volatility sequences, especially given the persistence of political risks (Italy, Brexit and the European elections), geopolitical risks (Saudi Arabia and Iran) and commercial risks (China - United States).

Gaëlle Malléjac
Active Management Investment Director

The Groupama AM management team is rebalancing its portfolios, with a view to weighting the risks and favouring liquidity, while preserving a highly selective, stock-picking approach. On the question of the fixed-income markets, the American 10-year Treasury Note is expected to continue to rise at the rate of 30 base points in 2019 and therefore attain a balanced level. In the eurozone, the “core” rates are expected to progress, given the economic fundamentals. “Our strategy remains prudent on fixed-income markets, to which we are globally under-exposed. Our preference is for inflation-indexed bonds, and we will preserve a prudent and opportunistic positioning on Italian debt. The phases of volatility provide us with attractive entry points,” explains Gaëlle Malléjac.

On the corporate bonds market, the fundamentals remain good and are close to their high point, but the technical factors are negative. “We have observed a general widening of spreads since March 2018. In Europe, risk premium levels already include various risks relating to Italy or Brexit, which explains the under-performance of this asset class during this year compared to its American equivalent”. Over the next few months, the credit market is anticipated to be more dependent on cash-flow effects and more sensitive to volatility: technical factors are weighing down the market, and the end of the ECB’s asset purchases and the shrinking of the Fed’s balance sheet are inciting certain investors to pull out of the market.

 

2019: prospects still good for equity

“Under these conditions, we are maintaining a carry strategy, with a preference for the European high-yield segment, which will be less sensitive than the investment-grade segment to the end of the European Central Bank’s quantitative easing. We will remain selective in our choice of stock, in view of the specific risks, and we will combine this approach with active management via derivative instruments, which we consider to offer greater liquidity.” Additionally, emerging debt has retained its attraction, with good yield prospects, provided that exposure to risk is limited via securities denominated in strong currencies.

Finally, the prospects of the equity markets are still positive, with the overall economy supporting the growth of corporate profits, as can be seen from the robustness of the results published in the third quarter. “We anticipate profit growth of 5 to 10% in 2019 for companies in the developed countries”. Like the credit market, asset values on the stock markets have already integrated the increased risks, which held back valuation multiples this year. “Valuation levels are gradually returning to their long-term mean, close to 13 times EBIT in Europe, and 15 times EBIT in the United States – which are attractive levels,” observes Gaëlle Malléjac. “However, we envisage a moderate over-weighting of equity in our portfolios, since the return of volatility is likely to affect the risk/return of equity”.

The Groupama AM team continues to prioritize several long-term themes on equity markets: stock-picking focuses particularly on shares the profit from investment permitting increases in productivity and on companies favourably exposed to mergers and acquisitions. More recently, the theme of companies distinguished by high visibility has developed. “We identify stocks having a safety margin, reflected in high visibility of their activity, a stock market valuation that is judged to be low and a reduced sensitivity to cycles and to the risk  of disruption. This resilience is a characteristic of so-called ‘defensive’ stocks, a segment where we adopt a selective approach,” concludes Gaëlle Malléjac.

 

*pricing power : ability of companies to impose their selling prices, due to factors such as high barriers to entry, high innovation capabilities or a distinctive added value compared to its competitors

 ** LTRO & T-LTRO :  ‘Long Term Refinancing Operations’ –  the refinancing facilities granted to banks by the ECB

 ‘Targeted Long-Term Refinancing Operations’ –  specifically targeted refinancing facilities granted to banks by the ECB

 *** quantitative easing: introduction of new money into the economy by central banks

                       

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Edited by Groupama Asset Management – Headquarters: 25 rue de la ville l’Evêque, 75008 Paris – Website: www.groupama-am.com