H2 2018 outlook: Consolidation with near-term sunny spells
• Near-term indicators for the global economy are positive; consumer spending rebounds and capex is supported by rising profits and strong confidence • Even if the environment looks supportive for risky assets, several risk factors linked to trade and Eurozone politics may temper investor sentiment • Equities receive support by earnings growth, an attractive risk premium and cautious investor positioning • The risk/reward equation has deteriorated, better diversification into new alpha sources is key. Opportunities exist in Multi Asset Credit solutions, Short Duration Emerging Markets Debt, Frontier Markets Debt, Alternative Credit, Sustainable Equity, Factor Investing and Convertibles
The accelerating global economic growth seen in 2017 has morphed into a further consolidation. Additional fuel needed for a further acceleration like profit and employment growth, an improvement in confidence, or additional declines in savings rates is increasingly hard to find, according to NN Investment Partners’ (NN IP).
Valentijn van Nieuwenhuijzen, Chief Investment Officer at NN Investment Partners: “The crucial question for markets today is how long the current period of economic consolidation will last. Near-term indicators are positive, with consumer spending rebounding, capital expenditure supported by profits and confidence while traditional showstoppers are not flashing red – wage inflation is moderate, companies’ investment levels are not at excessive levels and their leverage is generally much lower than in 2008.
“The key issues over the next six months will revolve around US trade policy and the risk of a trade skirmish evolving into an outright trade war and Eurozone politics where the stance of the Italian government on budget and reforms relative to the rest of the region will be crucial.
As far as monetary policy is concerned, the path towards normalization is pursued. The Federal Reserve will continue to tighten beyond neutral but is not in a hurry. The Fed looks also prepared to tolerate a moderate overshoot in inflation in order to avoid threatening the recovery “The ECB from its side will taper its QE program in Q4 towards zero but has at the same time introduced time and state dependent forward guidance on the timing of the first rate hike. We still consider this move as a hawkish shift in the ECB reaction function. There is a risk that this will prevent the ECB from fulfilling its price stability mandate.
Equities are supported by a number of positive fundamental and behavioural dynamics. Global earnings growth is solid both for this and next year, even if the absolute pace of growth will moderate in 2019. In addition our global cycle indicator, which captures a wide range of leading indicators has turned up again. Finally the equity risk premium remains attractive. From the behavioural side we note the strengthening price momentum and cautious positioning. The latter can be explained by the high uncertainty with regards to trade policy and (geo)politics in general.
Within equities NN IP maintains a balance between late cyclical sectors and defensive sectors. Regionally the US market is preferred as this is currently the safe haven market. For EM equities NN IP is more cautious as a number of headwinds like a strong dollar, high oil prices, rising Fed expectations and the risk of an escalation in trade tariffs risk dampening the regions’ growth and earnings prospects.
Patrick Moonen, Principal Strategist Multi Asset at NN Investment Partners: “Although politics continues to dominate investors’ attention and has impacted their sentiment negatively, in practice it is not always easy to predict to what extend markets react to political news flow.
“In the Eurozone, however, political events recently have raised attention with populists parties now governing in Italy. It will be important to assess how confrontational they will be with the rest of the Eurozone on budget matters and the path towards debt sustainability.
The outlook for fixed income markets is overshadowed by the headwind created by rising interest rates and monetary policy normalisation. Despite some setbacks and increased uncertainty regarding economic momentum, there is still fundamental support for spreads. The level of economic growth is strong and default expectations are low, which supports a low level of spreads. There has been a widening trend in spreads across categories this year and valuations have improved as a result, although they are relatively tight on an historical basis. However, momentum, sentiment and investor flows are negative, which warrants NN IP’s small underweight in spreads for now.
Pieter Jansen, Senior Strategist Multi Asset at NN Investment Partners: “Emerging Markets Debt (EMD) has seen weakness this year despite strong underlying fundamentals. A combination of underlying factors, such as the rising US dollar, higher commodity prices, macro and political uncertainty and country specific risks seem to have triggered the recent correction, in which negative performance and outflows seem to have fed each other. Second, several EM currencies have also seen significant weaknesses this year.
“Overall, we are neutral in EMD. We favour Frontier Markets Debt (FMD), which offers higher yields together with shorter durations compared to EMD generally. Frontier market economies are likely to grow at a higher rate than developed and emerging economies and given improving fundamentals and attractive valuations, we continue to expect positive returns from this asset class for the medium and long term.”
The environment is still supportive for risky assets but we experience a deterioration in the reward/risk trade-off as a consequence of increased volatility and the impact of interest rate normalization. In such an environment where do we see opportunities?
- Multi Asset Credit Solutions: Decades of declining yields and the prospect of gradually rising interest rates demand a different way of investing in fixed income, with a dynamic credit allocation that combines return sources.
- Short duration Emerging Markets Debt (HC) offers an attractive yield, while offering protection to investors that are concerned about the impact of potential US rate hikes.
- Alternative credit adds value in portfolios in times of rising interest rates and volatility, offering predictable cashflows with high credit quality.
- Sustainable and impact equity captures the ESG alpha and offers long-term value creation.
- Factor investing, a proven strategy to diversify versus traditional investments while offering attractive returns.
- Convertible bonds capture long term equity like returns with much reduced volatility.
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