Market overview

HOLDING ON TO HOPE

MARKET BUOYED BY RATE CUT EXPECTATIONS

 

Equity markets have now fully recovered lost ground after the U.S. stepped up tariffs on China imports in early May. Bullish sentiment has been fueled by expectations of a reboot of U.S.-China trade talks and central banks cuts. Earnings momentum is improving after the U.S. Q1 earnings season delivered good news in terms of profits. The bond market however, portrays a different picture. Inflation expectations have dropped, especially in the eurozone, signaling a bleak macro outlook. Central banks have turned more dovish as below-target headline inflation offers some scope for lower policy rates.

 

Macro readings remain mixed. Manufacturing confidence is still sliding as the trade war has created greater uncertainty, dragging down investment plans. Growth had levelled off in the spring, but was then hit by the trade war escalation, leading to a string of underwhelming macro readings. Services, which mainly depend on private consumption, have started to edge downwards. A supportive policy mix and tamed inflation have overall propped up activity, but the effects of the latest round of tariff hikes have not been felt yet.

 

Global equities kept at Neutral. Abundant liquidity has lifted equities to year-to-date highs and should remain a strong support in the short run. However, we maintain a defensive stance from a country and sector perspective. We are prudent on Japanese and Emerging Market (“EM”) equities, as the trade war is a powerful headwind for these markets. We prefer high quality and high dividend stocks that offer attractive alternatives for investors searching for yields..

 

Double down on credit. The current environment is very supportive for corporate bonds (credit). Low inflation, dovish central banks, and limited default risks argue for increasing credit exposure. The hunt for yield is still on. Falling sovereign bond yields are pushing investors to seek lower-rated bonds. Credit spreads are stretched, but monetary policies should keep them tight. We have adopted a neutral duration on U.S. Treasuries, as upside risks on yields seem contained. Emerging Market debt, which has performed quite well year-to-date, should continue to do so as the Federal Reserve’s easing bias brings support to the asset class, as well as to issuers.

 

Beware of a shift in sentiment. Risk appetite is being bolstered by monetary policies. However, downside risks abound: geopolitics, with rising tension between Iran and the U.S.; trade, as U.S.-China tensions may not be resolved as fast as investors hope; and macro, as the weakening manufacturing cycle could spill over to services. For these reasons, investors should prepare to reduce risk if downside risks start to materialize.

 

ALTERNATIVE STRATEGIES

Within a context of significant monetary support and very low sovereign bond yields, we deem it appropriate to maintain an Overweight stance on carry strategies such as EM-focused Global Macro and L/S Credit. From a general standpoint, we still prefer Event-Driven vs. L/S Equity, and L/S Credit vs. Global Macro and CTA, but have made some readjustments for the sub-strategies. We maintain our O/W stance on Merger Arbitrage, as it offers a low correlation to equities and a low volatility in returns. The combination of stronger CEO confidence in 2019, lower financing costs, and record levels of private equity dry powder may lead to a supportive environment. M&A volumes have rebounded and deal spreads widened since early May, providing opportunities to deploy capital at attractive entry points. Finally, we upgrade Market Neutral L/S Equity to Overweight, at the expense of L/S Equity long bias (downgraded to Underweight). The strategy could now bring the protection sought by investors if consumer and business confidence is hit by trade tensions.