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Here’s reflation, well, for now

Global views and trends

BNP Paribas Asset Management

Recent geopolitical news has caused financial markets to trade in a reflationary fashion, shrugging off weak data and concern over structural Sino-US tensions, even if the economic slowdown may evoke memories of Q4 2018. Are the similarities actually there?, we ask in this issue of The Intelligence Report [1].  

  • De-globalisation relief – this may last in the short term, but further out, things look trickier.
  • Fixed income most at risk – that is, from any sustained move to a reflationary environment.
  • Weak data – but it is too early to call a recession just yet.
  • Key differences to Q4 2018 – central banks’ stance, asset valuations and investor positioning.

De-globalisation relief & reflation

Markets got a taste of reflation on the back of the latest geopolitical developments – hopes that a no-deal Brexit could be avoided and China and the US might bury the hatchet. Concern over both situations, seen as examples of de-globalisation, has driven markets recently.

The related uncertainty over the outlook has put major pressure on the prospects for global growth since late last year. The slowdown in manufacturing is evident, with economies geared to manufacturing (e.g. Germany’s) feeling the pinch, and with investment on hold.

However, the increased likelihood of a Brexit accord and of a Sino-US trade deal has offered investors a breather, causing growth assets to see some relief and bonds, and bond proxies, to sell off. In fact, eurozone equity prices and German bond yields rose in tandem. Indeed, bonds still stand out as rich across the main regions, and as such are at risk should reflation be sustained.

Exhibit 1: Equities and bond yields rise in tandem

Exhibit 1: Equities and bond yields rise in tandem

Source: Bloomberg and BNPP AM, as of 31/10/2019

In context: de-globalisation is secular

It should be remembered, though, that the Sino-US conflict has both a structural element – it is part of a sustained long-term move to a more de-globalised world – and a shorter-term cyclical aspect.

In the next three to six months, the de-globalisation dynamics could remain supportive. Ahead of the 2020 US presidential election, President Trump will surely act with an eye on his approval ratings.

In fact, the uncertainty over the conflict with China has not been helping: the equity market, whose fate has been tightly linked to Trump’s ratings, has suffered. So he could let up in the negotiations with the Chinese as the presidential election approaches.

Ultimately, to solidify reflation (i.e. growth), fiscal policy measures will need to be implemented more broadly. Counter-cyclical fiscal measures have been a cornerstone of the Trump administration’s policy. China is expanding fiscal stimulus. However, elsewhere, especially in Europe, the political intention is there, but there is no clarity on timing, size or scope.

Weak data, but no imminent recession

Since the market correction in Q4 2018, the slowdown has been a key concern for investors. The recent weakness has deepened and is now synchronised across the main economies.

However, we think it is too early to call a recession. Especially in the US, domestic (consumption) indicators have held up. Consumer confidence is nowhere near falling by as much as it usually does heading into recessions. In addition, initial jobless claims have remained near absolute lows. Crucially, they are not anywhere near the previous pre-recession levels.

Comparing the current backdrop to that of Q4 2018, we are seeing a similar slowdown in the macro data now. Political uncertainty is similarly high. The trade tensions are more negative now (bar the recent improvement) as positions have become more entrenched and tariffs are already in place.

This time is actually different

Among the key differences, major central banks are easing monetary policy, which contrasts with last year’s tightening bias, at the US Federal Reserve in particular. Although the Fed has indicated that it is likely to pause after three recent rate cuts, Chairman Powell made it clear that the hurdle to tighten policy is high. Other central banks – notably the ECB and Chinese policymakers – have started easing policy again recently. If market expectations are correct, this easing could persist.

Two other differences worth highlighting are investor positioning and valuations. Both are now supportive. Investors are positioned more defensively, compared to their bullish stance in late 2018. Relative valuations of equities and bonds make equities less rich now than in 2018. The gap between the S&P 500 earnings yield and US bond yields is almost 200bp wider than before the 2018 sell-off.

Asset allocation

So, our base case remains ‘fragile goldilocks’. We continue to be nimble in our asset allocation views. Having taken off our overweight last month, a renewed correction in global stock markets has allowed us to once again add to market risk via US and European equities. In terms of factor exposures [2], Market Risk is the most prevalent exposure.

Exhibit 2: Current factor exposures* from core asset views

Exhibit 2: Current factor exposures* from core asset views

* The factor exposure shown is for an unconstrained theoretical portfolio and derived from core asset class views. These factors will be projected onto individual portfolios taking constraints into consideration. Additional specific/tactical trades may be implemented and these will not be visible in the factor profile. They are listed at the end of the full publication. Source: BNPP AM, as of 31/10/2019

As said, in major bond markets, a lasting reflationary shock represents a major risk. However, after a near 40bp backup in core EMU bond yields, we have reduced our short exposure. This trade adds negative Duration to portfolios. To offset this, we hold an overweight in EM hard currency debt, motivated by the search for yield amid central bank easing. This position adds Duration exposure and introduces exposure to the EM & Commodities factor.

[1] This is an extract of the latest Asset Allocation Monthly by the MAQS team at BNP Paribas Asset Management. For more comments and factor views, read the full monthly here.

[2] Also read: Using multi-factor allocation in portfolio construction

This article appeared in The Intelligence Report – 12 November 2019

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Views expressed are those of the Investment Committee of MAQS, as of November 2019. Individual portfolio management teams outside of MAQS may hold different views and may make different investment decisions for different clients.

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