Is the 90-day truce between the US and China symbolism, or will it deliver real substance? Whether the world’s two biggest economies can solve their sharp differences is far from clear at this point.
President Xi Jinping cannot risk making any concessions that would jeopardize China's 10-year manufacturing plan to become self-sufficient by 2025 in 10 key high-tech industries and eventually dominate the global market in those industries. President Trump, determined to stop China's theft of intellectual property and forced technology transfer of western companies and to revitalize US manufacturing, won't give in easily either. The trade war has already materially damaged US businesses, the global growth outlook and investor sentiment. A resolution is urgently needed – the sooner than 90 days, the better.
On a tactical horizon, we have opened an overweight to Equities as we believe the asset class looks reasonably attractive and the recent sell-off was overdone. Also this month, we underweight Fixed Income and overweight Alternatives.
Within Fixed Income:
- Within fixed income we are starting to see a relative attractiveness of US fixed income coming through. This is driven mostly by higher rates in the region as a result of hikes by the Fed in response to robust economic growth in the US.
- As a result, within government bonds we are overweighting the US over the EU, which in turn makes the whole sub-asset class an overweight.
- We are underweighting investment-grade debt as we view the risk-return trade-off as unattractive.
- The supportive macroeconomic environment is the main reason we have an overweight in (US) high yield.
- Our emerging-market debt and securitized positions are close to the neutral benchmark weights.
- This month our overall view on equities has turned more positive as we believe equities look reasonably attractive and the recent sell-off was overdone.
- Sentiment is a negative driver for the overall equity market in our opinion.
- Strong fundamentals are the main reason we like US equities, but valuations are also a positive factor.
- In China we see that local authorities are supporting the economy, and therefore the equity markets too. We have also observed an improvement in sentiment towards the region in the last several months.
- On a relative basis, our views on commodities and distressed loans are quite similar. We are therefore neutral on both within the alternatives bucket.
Figure 1: Our asset class overweights/underweights in our model portfolio as of January 1, 2019 on a 3-month horizon. Each percentage reflects the relative weighting of the different asset classes within our model portfolio.
Fixed income – Government bonds
US: Negative. Fundamentals are neutral. With unemployment under 4% and core PCE almost 2%, the Fed has achieved its dual mandate of full employment and stable prices. We also believe the Federal Funds rate is already very near the neutral rate and that as a result the Fed may hike rates less than expected. That said, slower global growth, tariffs on China and the uncertainty about Brexit make it hard to predict outcomes.
Valuations are almost neutral. Treasuries are close to their fair value on an outright basis. 10y Treasuries remain rich compared to other currency-hedged developed-market sovereigns after taking hedging costs into account. Future FOMC hikes are largely priced in, and the market is starting to price in rate cuts. This could continue to flatten the yield curve.
The biggest shift in our view of US rates is in sentiment, which has turned negative due to the extreme bullishness for both 10Y and 30Y Treasuries. Speculative Treasury future positions have been reduced as banks had to reduce their balance sheets year-end 2018; this situation could tee up a sell-off in Treasuries. Technicals are also negative. Momentum indicates that we may have seen the near-term highs in Treasury prices.
Europe: Negative. Fundamentals are neutral. Q3 GDP growth figures deteriorated, presumably due to weaker auto production. Although this effect appears to have faded, other factors are also putting a drag on growth and inflation, which has prompted the ECB to lower its projections on growth and inflation and indicate that downside risks have increased.
Valuations for European rates remain negative and German yields are too low based on fair value. Sentiment remains negative too. Some sentiment indicators show that investors have gone from very bullish to bearish in just two months — and that could be reversed in the next few months, for example if investors decide to allocate to other assets than low-yielding bunds. Politics still dominates sentiment, starting with Italy (which got its way with its spending plans and will not be punished by Brussels) and continuing with the implications of different Brexit scenarios. The market remains very sensitive to the flow of news on these issues. Liquidity is thin. Technicals are positive.
UK: Positive. Fundamentals are neutral as the outcome of Brexit is completely unclear. Our base case is still that Parliament will initially vote no on the deal reached with the EU and that the EU will not change anything in the current agreement. Growth continues to be one of the lowest in the G7. Inflation remains stable at 2.4% and labor-market data continues to be strong.
Valuations are negative. May 2019 is the most likely date for the next rate hike. The long end of the curve remains well supported. Sentiment is positive. Brexit has kept gilts low, which has dampened business activity. However, this could quickly turn from a headwind to a tailwind if the Brexit outcome is clarified quickly. Technicals are neutral.
Japan: Negative. Fundamentals are negative. Though economic activity has picked up, the Bank of Japan is maintaining its very expansionary policy, even as policymakers worry about the imbalances this policy could cause. The outcome of the trade war between the US and China will be crucial for fundamentals because Japan has, until now, been the main provider of high-tech components to China. Valuations are still very negative, as the 10-year rate remains close to zero. Sentiment, still anchored by the central bank's yield control curve mechanism, is negative. Technicals are also negative.
Fixed income – Investment-grade
US investment-grade: Negative. Fundamentals are neutral. The macroeconomic environment is starting to witness a deceleration in growth as the boost from the fiscal stimulus wears off and the trade-war rhetoric worsens the outlook for global growth. On the micro side, earnings remain strong, but earnings growth rates have likely peaked. Also, leverage remains too high. The market has tried to justify the high leverage by indicating that it's spread across the most stable sectors and issuers. But the fact remains that 50% of the corporate index is now BBB rated. That is significant, particular this late in the credit cycle.
Valuations for US investment-grade debt are negative as spreads are quickly approaching their long-term average. Also, spreads continue to appear rich when adjusted for leverage or duration. Positioning indicates that most investors are overweight at the short end. Sentiment is neutral — investors are definitely focusing more on corporate fundamentals. Finally, technicals are neutral. A very quiet new-issue calendar in December will give way to the typical deluge at the beginning of this year. It's estimated that supply is likely to fall by around 10% from 2018 levels (which was already below 2017 levels). The unwinding of global QE will continue to erode technicals at the margin, and as cash gets absorbed into other sectors, we may see more volatility in this asset class. Higher FX hedging costs, which contributed to lower foreign demand in 2018, will likely also deter investment from abroad in 2019.
European investment-grade: Negative. While PMIs in Europe are slowing, on average they still indicate economic expansion. The inflation outlook is still very modest in the EU. Defaults are at their lowest levels ever. All in all, fundamentals are neutral this month.
Valuations have turned positive because spreads have widened materially and are close to their highest level in the last five years. Sentiment is negative. The overall risk appetite remains low: the market is still concerned about Italy and Brexit. Technicals are neutral. The ECB has purchased 170 billion euros of investment-grade debt over the last two years, but the ECB will no longer be a big buyer as its credit purchase program will cease. The spreads on paper that the ECB used to buy may suffer as a result. Technicals are neutral: Supply is very light, and some deals have been pulled. In short, there's a lot of uncertainty about this asset class. The outflows of 2018 are likely to continue this year.
Fixed income – High yield
US high yield: Modestly positive. We're upbeat about high-yield fundamentals. The US economic growth continues to provide a supportive backdrop to US high-yield companies. Q3 delivered another quarter of solid earnings, with few idiosyncratic one-offs. Also, interest coverage and cost pressures are declining. Valuations are neutral this month as the market is still trading well within long-term averages. Sentiment is neutral, mainly driven by the overall weak tone in investment grade. Technicals are modestly positive as there has been little issuance in 2018 and the lull is expected to continue in 2019.
European high yield: Negative. Fundamentals are neutral. The credit cycle in the EU has slowed down. In general, company results are in good shape, despite some signals of margin pressure. However, levered companies with little to no free cash flow as well as short maturities will have a tough time.
Valuations are positive because relative to defaults, high-yield spreads are still decent. However, sentiment is very low: investors are very risk-off due to the fall in equity markets. The general risk-off nature of the market combined with trade tensions are weighing more on sentiment than the issues of Italy and Brexit. Technicals are neutral. Supply is low and the outflows continue. Liquidity is driven by redemptions, calls and coupons.
US leveraged loans: Negative. Fundamentals are neutral: earnings are generally growing and default expectations remain low. But we are seeing higher secured leverage – that worries us. Valuations are positive. More value has emerged in various pockets of BBs and Bs, with almost all loans below par. And if you select smart, you'll find some value left in distressed and CCC loans. The rise of LIBOR and fewer re-pricings have, overall, led to a higher total coupon.
Sentiment is negative. Market volatility has also halted a lot of issuance. Technicals are also negative: USD 36 billion has come into this asset class since 2016, and a lot of that is now leaving. Primary issuance is coming at a discount and the secondary market has cheapened. The CLO machine, still the largest buyer of loans in this market, has slowed too.
Fixed income – Emerging market (EM) debt
Emerging markets: Negative. 2018 was clearly a bad year for emerging markets. But it's part of a pattern: every five to 10 years, emerging markets get pushed into a corner. Then things improve.
This month, fundamentals are neutral. The tail risks regarding global growth and the intensification of trade tensions have damaged the risk environment. Valuations are positive as they remain attractive on a relative basis. We expect the EM spread to widen over the next few months, but that will be offset by carry. EM local-currency debt will remain rangebound.
Sentiment is negative. China's President Xi has been more defiant in his recent speeches, indicating he is unlikely to give in to concessions to the US. This could be a headline risk for emerging markets in 2019. Investors will be carefully watching the new trade dialogue between Presidents Trump and Xi. China's response will impact the growth outlook and asset performance in emerging markets.
Technicals are neutral. Bond outflows, which have been concentrated in the retail part of the market recently, are starting to moderate. EM sovereign issuance in the next few months will likely be focused on countries where there are immediate financing needs, such as Turkey, Lebanon and Poland. Low net supply will keep technicals supportive for emerging -market sovereign and corporate debt.
Fixed income – Securitized
US securitized: Positive. Fundamentals remain healthy in most securitized markets. While delinquency and default trends in certain ABS sectors have risen, the current levels are not a cause for concern. The US housing market, still positive, is showing signs of moderating. Home valuations keep rising, but the pace of appreciation is likely to decelerate.
Valuations remain negative as spreads should remain rangebound. Agency MBS look rich based on nominal and OAS spreads. CLOs show relative value, especially on a risk-adjusted basis. Sentiment is neutral. According to an investor survey in the fourth quarter, 38% of respondents expect to increase their allocations to securitized products, and 94% to maintain or add to their securitized-products allocation. Technicals are positive. That said, we are negative on Agency MBS. The monthly reduction of Agency MBS has reached USD 20 billion per month,and we are concerned who the incremental buyer will be to absorb that extra paper.
European securitized: Negative. ABS fundamentals are positive. Arrears are stable to improving, the UK consumer sector is stable, and house prices are still trending upwards (except in London). EU fundamentals show only small cracks: namely, that growth is slowing and consumer confidence is waning.
Valuations are close to zero as spreads have widened. CLO spreads are correlating more to credit markets. Sentiment is still positive, but less so than last month, mainly due to political risks and the general risk-off sentiment. Technicals are negative as the demand from traditional investors (such as the ECB and banks) will further decrease in 2019.
Equities overall: On a tactical horizon we have opened an overweight to equities as we believe the asset class looks reasonably attractive and the recent sell-off was overdone.
US: Negative. Reflationary deficit spending should drive nominal growth and support corporate earnings growth. The enacted tax policy could sow the seeds for the next cyclical upturn. Potential wage inflation could put pressure on margins. US equities are close to fair value. Sentiment is negative. Technicals are neutral.
Europe ex-UK: Negative. The current stage of the macroeconomic cycle in Europe is supportive for equities, but further upside is limited. Valuations are mixed and close to neutral on average. Sentiment remains negative based on a combination of indicators. Technicals are slightly negative too.
UK: Negative. The outlook for the UK economy is highly uncertain due to Brexit, and fundamentals are neutral on the whole. Valuations are close to neutral as equity returns have been highly dependent on the pound. Sentiment and technicals are both negative.
Japan: Negative. Though structural reforms will help a little bit to increase growth, overall fundamentals are slightly negative. Valuations continue to be marginally positive. Sentiment and technicals are negative.
China: Negative. Earnings revisions have peaked and the global cyclical recovery is positive. The PMI (which is at around 50) and support from the authorities are supportive for Chinese equities. Valuations remain close to neutral. Sentiment is negative. Technicals are a headwind.
Emerging markets: Positive. Economic fundamentals for emerging markets have improved to neutral this month and PMIs have likely peaked. Valuations are positive as the developed-market discount has narrowed slightly (even though it's still high on a relative basis). Sentiment remains negative. Technicals are now positive.
REITs: Negative. Fundamentals have improved. The demand/supply picture seems in balance and there is evidence of good office rental growth (though the retail sector is still suffering). As a defensive asset class, the last two months have been great for real estate, with listed real estate markets up 1.3% since our last House View. However, valuations have started to deteriorate. Sentiment remains negative too. The normalization and/or slight decline of rates seems more than priced in. Technicals are a headwind.
Distressed credit: Negative. The fundamental backdrop is still OK, despite inflationary concerns. Defaults will probably drop in the first half of 2019. All in all, fundamentals are modestly positive. Valuations are positive too because yields have widened. Sentiment is now negative: the recent sell-off in equities worries investors in this market. Also, the weakness in credit has extended into leveraged loans. Technicals are also negative as outflows have picked up.
Commodities – oil: Negative. Fundamentals are positive, despite the large oil production worldwide. Saudi Arabia has exported record amounts, which has surprised the market. After the recent price drop, OPEC announced production cuts in order to balance the market. Global demand forecasts are being lowered due to slower economic growth.
Valuations are negative due to the steep contango (i.e., when the expected spot price is lower than the current price). Sentiment is neutral: on the one hand, sentiment seems quite panicky; on the other hand, analyst readings are bullish. Technicals are not signaling a rebound anymore, so they are negative this month.
Commodities – ex-energy: Negative. The global macro economy is in the expansion phase. The roll yield is negative and less than the seasonal historical average, so valuations are negative this month. The strength of the dollar should also be a headwind. Sentiment is neutral. CFTC positioning is supportive for ex-energy commodities. Analyst readings are somewhat neutral for sugar and copper and bullish for corn. Stress in ex-energy commodity spectrum has increased recently. Technicals are close to zero.
About the House View
Aegon Asset Management operates from centers of expertise in North America, the UK, Continental Europe and Asia. The Aegon Asset Management House View is updated on a monthly basis, and is an excellent example of how we leverage our international expertise. First, we collate a global set of asset class views from our international teams. The asset class views are subsequently reviewed from macro, rates and asset allocation angles and an overarching committee then establishes the global House View. The outcome of this disciplined global process provides portfolio managers with latitude while at the same time ensuring that our products and solutions remain aligned.
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