Choose Language
November 13, 2018
BILBoardBILBoard November 2018 – Climbing up the Quality Curve
October has been a ghastly month on markets, with almost every asset class having taken a hit. However, without significant deterioration in the fundamentals upon which our risk-on strategy was built, we decided to hunker down and leave our equity overweight as is. However, for fixed income investors, the time is nigh to start preparing for higher rates.
October’s correction, which had its roots in the US Tech sector, spread like wildfire through global risk assets. It seems to have been instigated by a host of dovetailing factors, the most prominent being the fear that the US Federal Reserve could act too hawkishly, after the Chairman, Jerome Powell, opined that the Fed was still a long way from reaching the ‘neutral’ rate (that neither stimulates nor contains growth). Another contributing factor was the idea that corporate earnings have peaked and that the trade war with China is starting to have a tangible negative impact on companies and the economy. These fears were compounded by the laundry list of worries hanging over the world economy: Brexit, Italy’s budget gridlock, US mid-terms and the IMF’s downward revision of growth expectations.
Firm fundamentals persist
As most of these risks had been on our radar since well before the sell-off, what was essential for us was to go through macro data with a fine-tooth comb to ensure that some other sands had not shifted, skewing the fundamental outlook that underpins our strategy. Whilst we believe that global growth has reached its peak, we must not confuse a moderation in the pace of growth with a contraction.
Whilst there are some imperfections forming, the US economy is still in a strong growth environment. Third quarter GDP growth came in at 3.5% (annualised) and financial conditions are far from stressed levels. Unemployment is at a mere 3.7%, and the overarching strength of the labour market has fostered a sense of job security, which in turn has allowed consumer confidence to hit an 18-year high. After new home sales dropped for the fourth consecutive month in September (by 5.5%), the Committee expressed some concern with the downward trend in the housing market. Further analysis indicates – at least at this stage – that this is a normal response to decreasing affordability rather than something more sinister. The most recent Case-Shiller Home Price Index shows that home prices continued to increase in October, albeit at a slower pace.
The macro picture in Europe has a lot more white noise. Official data revealed that the eurozone economy grew at a pace of just 0.2% in the third quarter. This was pretty disappointing given the expectations for growth to continue at Q2’s pace of 0.4%. There were a few transitory factors such as German car production being hit by new tests, but the key detractor was the fact that Italy registered no growth whatsoever.
Should rising US rates keep you up at night?
Rising rates are not a risk per se, if they move upwards in tandem with growth. On the other hand, a situation in which inflation moves above the Fed’s target, forcing the central bank to hike at a faster-thanexpected pace, as fiscal stimulus fades, would be very challenging.
For now, forward inflation expectations have come down on both sides of the Atlantic – more notably in the US, where wages have only now started to show meaningful increases and where capacity utilisation appears to have stabilised at 78%. Without any meaningful rise in inflation for the time being, we expect rates to rise more gradually and our expectations for the US 10-year yield are anchored below 4%.
As the Fed continues along its predefined hiking path, the 2-year yield should rise more rapidly. Investors could either complain about potential yield curve inversion, or about long rates going higher but not about both. Switching from one perspective to the other means investors will never get close to seeing the glass as half-full.
Equities
Rising rates (and yields) threaten the relative attractiveness of equities, but for now, rates are not high enough to pull the rug from under the equity market. Historically, the latter stages of the cycle have been fruitful for equities, and we maintain our preference for this asset class with a heavy tilt towards the US. Q3 earnings season has underlined the strength of corporate America – S&P 500 earnings growth thus far has been 24.9% YoY, and sales growth of 8.5%. We believe that the selloff was exaggerated (especially given the number of quant strategies which have automatic sell triggers that are activated by changes in momentum and volatility) and we expect a relief rally. Once the blackout period associated with the earnings season is over, buybacks should bring further support to the market. Albeit, as we traverse the later stages of the cycle, volatility will revert to more ‘normal’ levels (as opposed to the tranquillity that many became accustomed to in 2017).
We still have a lack of enthusiasm for European equities given the myriad of risks that remain.
Fixed income
To prepare for the new reality that higher rates will bring to fixed income, we have started to de-risk by climbing up the quality curve.
We reduced exposure to high-yield bonds and riskier tranches of the investment grade (IG) market, such as corporate hybrids and convertibles, adding core government bonds for ballast against future volatility.
In our lower risk profiles, we are happy to maintain exposure to senior tranches of the IG space in Europe. These instruments held up well during the sell-off, and amongst European corporates, leverage ratios are favourable, as is interest coverage. Hedging costs of 3.4% undermine the attractiveness of US IG for euro-based investors.
Whilst emerging market debt had a relief rally across September and October, we still view this segment as too risky
Conclusion
October was undoubtedly grim, but it is important not to let temporary stock market gyrations reshape one’s view of the economy. Whilst it may no longer be stellar, macro data in general is still strong enough to carry the equity market throughout the rest of the year, particularly in the US. However, in fixed income, it is time to start moving up the quality curve in preparation for higher rates and reduced liquidity as quantitative tightening ensues. As Warren Buffet once said, "Only when the tide goes out do you discover who’s been swimming naked.
Download the pdf version here (in French)
Download the pdf version here (in German)
Disclaimer
All financial data and/or economic information released by this Publication (the “Publication”); (the “Data” or the “Financial data
and/or economic information”), are provided for information purposes only,
without warranty of any kind, including without limitation the warranties of merchantability, fitness for a particular
purpose or warranties and non-infringement of any patent, intellectual property or proprietary rights of any party, and
are not intended for trading purposes. Banque Internationale à Luxembourg SA (the “Bank”) does not guarantee expressly or
impliedly, the sequence, accuracy, adequacy, legality, completeness, reliability, usefulness or timeless of any Data.
All Financial data and/or economic information provided may be delayed or may contain errors or be incomplete.
This disclaimer applies to both isolated and aggregate uses of the Data. All Data is provided on an “as is” basis. None of
the Financial data and/or economic information contained on this Publication constitutes a solicitation, offer, opinion, or
recommendation, a guarantee of results, nor a solicitation by the Bank of an offer to buy or sell any security, products and
services mentioned into it or to make investments. Moreover, none of the Financial data and/or economic information contained on
this Publication provides legal, tax accounting, financial or investment advice or services regarding the profitability or
suitability of any security or investment. This Publication has not been prepared with the aim to take an investor’s particular investment objectives,
financial position or needs into account. It is up to the investor himself to consider whether the Data contained herein this
Publication is appropriate to his needs, financial position and objectives or to seek professional independent advice before making
an investment decision based upon the Data. No investment decision whatsoever may result from solely reading this document. In order
to read and understand the Financial data and/or economic information included in this document, you will need to have knowledge and
experience of financial markets. If this is not the case, please contact your relationship manager. This Publication is prepared by
the Bank and is based on data available to the public and upon information from sources believed to be reliable and accurate, taken from
stock exchanges and third parties. The Bank, including its parent,- subsidiary or affiliate entities, agents, directors, officers,
employees, representatives or suppliers, shall not, directly or indirectly, be liable, in any way, for any: inaccuracies or errors
in or omissions from the Financial data and/or economic information, including but not limited to financial data regardless of the
cause of such or for any investment decision made, action taken, or action not taken of whatever nature in reliance upon any Data
provided herein, nor for any loss or damage, direct or indirect, special or consequential, arising from any use of this Publication
or of its content. This Publication is only valid at the moment of its editing, unless otherwise specified. All Financial data and/or
economic information contained herein can also quickly become out-of- date. All Data is subject to change without notice and may not be
incorporated in any new version of this Publication. The Bank has no obligation to update this Publication upon the availability of new data,
the occurrence of new events and/or other evolutions. Before making an investment decision, the investor must read carefully the terms and
conditions of the documentation relating to the specific products or services. Past performance is no guarantee of future performance.
Products or services described in this Publication may not be available in all countries and may be subject to restrictions in some persons
or in some countries. No part of this Publication may be reproduced, distributed, modified, linked to or used for any public or commercial
purpose without the prior written consent of the Bank. In any case, all Financial data and/or economic information provided on this Publication
are not intended for use by, or distribution to, any person or entity in any jurisdiction or country where such use or distribution would be
contrary to law and/or regulation. If you have obtained this Publication from a source other than the Bank website, be aware that electronic
documentation can be altered subsequent to original distribution.
As economic conditions are subject to change, the information and opinions presented in this outlook are current only as of the date
indicated in the matrix or the publication date. This publication is based on data available to the public and upon information that is
considered as reliable. Even if particular attention has been paid to its content, no guarantee, warranty or representation is given to the
accuracy or completeness thereof. Banque Internationale à Luxembourg cannot be held liable or responsible with respect to the information
expressed herein. This document has been prepared only for information purposes and does not constitute an offer or invitation to make investments.
It is up to investors themselves to consider whether the information contained herein is appropriate to their needs and objectives or to seek advice
before making an investment decision based upon this information. Banque Internationale à Luxembourg accepts no liability whatsoever for any investment
decisions of whatever nature by the user of this publication, which are in any way based on this publication, nor for any loss or damage arising
from any use of this publication or its content. This publication, prepared by Banque Internationale à Luxembourg (BIL), may not be copied or
duplicated in any form whatsoever or redistributed without the prior written consent of BIL 69, route d’Esch ı L-2953 Luxembourg ı
RCS Luxembourg B-6307 ı Tel. +352 4590 6699 ı www.bil.com.
Read more
More
December 9, 2024
Weekly InsightsWeekly Investment Insights
December is here, and while the cold, dark days may not be everyone's cup of cocoa, the festive spirit is starting to set in....
December 2, 2024
Weekly InsightsWeekly Investment Insights
In an age where you can carry a computer, music player, phone, TV, camera, calculator and notebook all in one small device that fits...
November 25, 2024
Weekly InsightsWeekly Investment Insights
After last week's disappointing Eurozone economic data, another ECB rate cut in December is high on the wish list for Europe, with investors increasing...
November 22, 2024
BILBoardBILBoard December 2024 – Red Sweep
At BIL, we are long-term investors guided by stable, strategic asset allocation guidelines. However, our investment strategy itself is a living, breathing thing,...
November 18, 2024
Weekly InsightsWeekly Investment Insights
Less than two weeks after the US Presidential election, Trump has made significant progress in nominations for top government posts, leading to some market...