Asset Allocation:

Stuck between cyclical slowdown and central bank easing


By Yves Ceelen, Head of Institutional Portfolio Management at DPAM

The stance (Overweight, Neutral, Underweight) is for a Medium (or Balanced) Portfolio expressed versus the Strategic neutral weight of that portfolio.

Government bonds: overweight

After a very strong month of May, bond markets continued their rally in June only to partly give back some of that performance in a sharp correction early July. US 10 year bond yields dropped back to 2,1% and 10 year German yields reached -0,25% after touching a historical low of -0,4%. As a point of reference, at the start of the current downtrend in early October, US yields were at 3,2% and German 10 year yields at 0,5%.

The main reason for this quite brutal move in market yields is the continued shift from central banks towards easier monetary policy. While this trend has been ongoing since the end of last year, it seems to have accelerated in recent weeks. Leading economic indicators are globally pointing to a continued weakening of economic momentum and inflation figures and inflation expectations are again declining. The market expectation for inflation in the medium term (the so called 5 year / 5 year forward rate swap) dropped to 1,8% (from just above 2% early May) for the US and fell below 1,2%, a fresh record low, for the Eurozone.

The key word for the Federal Reserve is no longer ‘patience’, but chairman J. Powell now says that the Fed will take ‘appropriate action to sustain the expansion’. The market now expects 2 to 3 rate cuts before the end of the year and 1 in 2020, starting in July. This is in line with our view.

In 2016, the drop in inflation expectations was the signal for the ECB to launch its quantitative easing program. ECB-president Draghi was even more explicit than before regarding the direction of monetary policy: both rate cuts or a new bond purchase program are possible. The appointment of Christine Lagarde as prospective president at the helm of the ECB very likely means that the dovish monetary policy pursued under Draghi will continue.

Periphery bonds performed very well with spreads dropping for Spanish and Portuguese bonds. After an initial hiccup around the time of the European elections, Italian bonds saw their spreads decline sharply to 190 basis points after having touched 285 at the start of June. With the Italian government seemingly wanting to avoid a new confrontation with the European Commission, investors clearly favored the region in their search for yield.

Because of the drop in inflation expectations, valuations for inflation linked bonds have become very attractive. We therefore have taken on an overweight position in global inflation linked bonds as a hedge against unforeseen inflationary scenarios.

EUR IG corporate bonds: underweight

As the central bank induced search for yield continues, EUR Investment Grade bond spreads contracted from 70 to 49 basis points – thereby more than reversing their May spread widening.

With spreads again at their March ’18 level and after the leg down in interest rates, absolute levels of yields for the corporate universe are at record lows.

Supply and demand remain well balanced. Primary market issuance boasts high cover ratios.

In a bond market that sees more and more negative yielding assets, investors will stay interested in bonds that offer an extra yield.

We maintain our Underweight stance for EUR Investment Grade.

EUR high yield bonds: underweight

As for the IG segment, corporate High Yield rallied in June.

Although there are distressed issuers in the European HY market, most of them are idiosyncratic. Defaults are expected to remain low for now and we do not see exaggeration in terms of leverage.

We confirm our Underweight position on European HY. Credit picking and thus active management remains key.

LC emerging market bonds: overweight

After some initial volatility in May, EM bonds benefited greatly from the dovish stance of developed markets central banks. Not only does it make their yield levels more attractive, it will also allow EM central banks to give air to their economy by also adopting a more dovish monetary policy.

Local Currency spreads have tightened but remain attractive.

EM currencies have also rebounded somewhat on the back of an easing in trade tensions between the US and China. The evolution of the US dollar will be important to monitor. After a false break down, the dollar is again weakening somewhat.

It confirms our conviction in the Overweight position.

Equities: underweight

Economic growth continues to show a negative momentum, but this is mainly due to the industrial part of activity. In general, uncertainty is hurting business confidence and investments are being postponed.

The consensus EPS growth across regions have again been revised down slightly. But expectations still look unrealistic in Europe (+2.3% for 2019 and +9.7% for 2020). We expect 2019 EPS to end up around zero. However, we do not expect an earnings recession, as the non-industry part of the economy is doing fairly well.

We expect volatility to remain a prominent factor for equity markets in the coming months: growth concerns (China in particular), a possible resurfacing of trade conflict, Middle Eastern tensions, and for Europe the Brexit and Italian risk. This pleads not to neglect the diversifiers in a portfolio.

On aggregate, we maintain a slight underweight to neutral position for Equities. With markets stuck between a cyclical slowdown and central bank easing, we do not advocate a too negative position. Central banks stand ready to add more stimulus, supporting growth and valuations (allowing lower earnings to be compensated by higher multiples), while China will provide more stimulus with monetary and fiscal measures. We consequently believe that the current deceleration in growth (and earnings) is a slowdown in a longer expansion.

  • European equity: Valuations remain attractive, but consensus’ earnings expectations remain too optimistic in our view. Political issues (Brexit, Italy) continue to weigh on sentiment. We consequently see no trigger to close that valuation gap. From a bottom up perspective, the European market is of lower quality and is in its composition more dependent on financials and disrupted industries. However, we continue to believe strongly in the potential for active management to outperform in Europe and thus hold a neutral position.

  • US equity: Valuations are less attractive relative to bonds and to European equity, while earnings growth is comparable to Europe. But, share buybacks continue to support EPS growth and quite importantly, the weight of disruptive companies in US high in the US. Additionally, it offers higher quality companies and often a more resilient market. We remain overweight.

  • Japanese equity: Japan remains one of most cyclical exposed markets, with large weights in capital goods and auto. We expect the sales tax increase planned for October to pose a headwind for the economy in the short term. Earnings growth expectations for 2019 are declining further and have reached -7%, but larger stock buybacks could temper the negative news flow. Over the medium term, valuation stays attractive and monetary policy remains extremely accommodative. The JPY continues to play the role as a safe haven currency, potentially dampening the moves of Japanese equities in euro terms. We keep our underweight position.

  • We have a neutral stance on the Emerging Market equity and believe that China has the capacity to manage its growth slowdown with additional monetary and fiscal measures, even in case of a further escalation of the trade conflict with the US. Mild outflows have again made room for inflows. Valuations are below the long term average and the risk premium is the highest of the regions within our investment universe. A stabilizing or somewhat weaker dollar would be supportive for the Emerging region.


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