Quantitative Easing (QE): The great unwind kicks into gear

Key points

  • The QE tide is reversing, putting downward pressure on asset prices and upward pressure on correlations
  • We take a less positive view of risk assets and look to downgrade equities to neutral over the course of 2019
  • We do not expect bund yields to break above the 0.2-0.7% range in 2019 and see value in treasuries above 3.25%

A year of no return

2018 has been a frustrating year for investors. Despite a fair economic backdrop and strong earnings growth in most parts of the world, the performance of global markets was poor. At the time of writing, all major liquid asset classes have posted negative total returns year-to-date (Exhibit 1). While these are expressed in local currency terms, the picture is slightly better for a globally diversified euro investor who has enjoyed the depreciation of the euro against the dollar since the spring. By far the biggest swings have been experienced in commodity markets where oil prices enjoyed a bull run that ended abruptly in October.

Exhibit 1: nowhere to hide

Source: JPMorgan, BAML, Barclays, GSCI and AXA IM R&IS calculations
Note: global indices in local currency terms

The paradox is that this poor market performance has come at the same time as strong improvements in fundamentals. For calendar year 2018, corporate earnings are set to have gained 24% in the US, 5% in the Eurozone and 19% in EMs. A lesson for this year may be that market gains in 2017 had possibly already priced and discounted 2018 growth while looking forward to less rosy news in 2019.

The quantitative easing tide

An alternative explanation – and a theme we had highlighted in our 2018 Outlook -– is the end of QE as the reversal of a tide that would put downward pressure on all asset prices. A number of factors are pointing in this direction.

First, valuations have deteriorated across all the main asset classes in 2018, be it government bonds, credit or equities. As a result, diversification has started to work less well between bonds and equities, suggesting that something more than just a simple switch between risk-on/risk-off assets has started to drive markets. Second, the sleeping volcano, volatility, has awaken. The market moves in February provided a striking illustration of volatility breakouts while a more gradual but persistent increase in the CBOE volatility index (VIX) has been evident since early October.

Developments over the course of 2018 support the idea that QE should be seen as the stock of assets currently owned by central banks globally. As such, it is only this year that QE started to be unwound and 2019 will be the second year of that process.

Embracing low returns

If this is correct, 2019 could prove just as challenging as 2018. The Quantitative Tightening steamroller may translate into both lower expected returns and higher correlations than usual. It may be wise to embrace low returns and refrain from increasing risk as a way to capture higher performance.

This view underpins our decision to shift our asset allocation down a gear. We have a less positive view on risk assets and are looking to downgrade equities to neutral over the course of 2019. We also maintain an underweight position in credit while keeping cash and government bonds at neutral.

Interest rates – monetary policy divergence set to continue

The divergence between the US Federal Reserve (Fed) and the European Central Bank (ECB) has been a major driver of rates markets over the past three years. We expect this tendency to continue in 2019, with the Fed hiking rates another three times to 2.75-3.0%, above market expectations. On the other hand, the ECB will likely take stock of the current growth deceleration and there is a risk that the liftoff might be postponed into 2020. The Euro overnight index average (Eonia) curve is currently pricing in the first 15bp hike around February 2020.

Treasuries reaching equilibrium levels

Looking along the yield curve, 95% of this year’s 70bp increase in nominal treasury yields is almost entirely due to the move in real yields. Inflation expectations have contributed very little to rates markets (only about 5% in the US) and we expect this theme to also continue in 2019. An inflation surprise is still in the cards given the economy is currently operating at full employment, but we think the probability of such a surprise remains a minor one at this stage. We see value in Treasuries above 3.25%.

Bunds trapped in a range

European rates are still an entirely different story, with widespread heterogeneity across the area and some signs of contagion appearing in peripheral fixed income markets as well as the banking sector. The ECB’s strategy will remain tilted toward prudence, patience and persistence, as long as the political jitters in Italy continue.

As a result of the ECB’s cautious stance (very limited normalisation of monetary policy and term premium), inflation disappointing (stable breakeven) and Italy (political risk premium), bund yields should remain capped and range-bound, keeping French OATs anchored. Also, we see little room for inflation expectations to move higher in a context of core inflation flatlining in 2019 and after the recent correction in oil prices.

This implies a neutral position on Eurozone core and semi-core bonds and breakevens. We do not expect bund yields to break above the 0.2-0.7% range in 2019.

Implications for yield curves

The US curve is likely to continue trading close to “inversion” levels, as suggested by the forwards (Exhibit 2).

We think that only a more aggressive rate path could tilt the curve deep into negative territory, sending a distinct slowdown signal to the US economy. Risks (that include the US’s trade war with China, European politics, potential concerns over China’s economic growth) and the limited upside on bund yields should help cap the long end of the US curve. However, the heavy pace of treasury issuance should also limit the downside on yields. All in all, we maintain a long position on 10Y US treasuries, partly as a diversifier in case of a more pronounced macroeconomic slowdown.

The EUR curve is likely to be driven by a complex combination of rates expectations, political noise and market positioning. In the environment of low interest rate volatility, the EUR-forward space is likely to attract carry-hungry investors in 2019, thus preventing the curve from realising the flattening implied by forwards. However, positioning is a double-edged sword and could lead to substantial volatility in the event of a sudden repositioning.

Exhibit 2: USD and EUR yield curves & forwards

Source: Bloomberg and AXA IM R&IS calculations

The Italian situation has deteriorated as tighter financial conditions and weak business confidence have continued to weigh on growth, offsetting the fiscal stimulus. The public debt ratio may move higher if the budget deficit hovers above the 3% threshold, leading to more confrontation between the Italian government and the European Commission. In this context, we expect Italian 10 year bond yields to grind higher and settle above 4%.

Credit – dancing with bears

The current market correction is giving credit investors pause for thought. The key question is to determine whether the credit cycle is finally turning or whether markets are simply experiencing yet another air pocket.

US dollar high yield (HY) spreads, for example, broke out of their unsustainably tight spread range in October and have continued to widen in November. But they remain within the historic norms of credit spread behaviour within hiking cycle by the US Fed. By the same historic norms, a true turn in the credit cycle could be over a year away, which chimes with our macro view of a slowdown in US growth in 2020 with risk of recession in 2021.

Timing the cycle notwithstanding, credit spreads are likely to remain under pressure in 2019 due to a host of macro headwinds and a less advantageous technical backdrop. But, the more we widen into year- end, the weaker the bearish argument for 2019 given that credit valuations inevitably improve with spread widening. We take note of the fact that credit spreads are already wider than the levels we saw at the end of 2016, which were followed by a spread rally in 2017 (Exhibit 3).

The Achilles heel of credit markets in the current cycle is the record share of BBB-rated credits, which raises the spectre of downgrade risk into HY. The problem is more significant in the US, where jumbo acquisitions have left certain investment grade (IG) corporates at levels of leverage that exceed IG norms. This means that they are very dependent on strong profits in order to reduce leverage and avoid dropping into a HY rating over the next 2-3 years.

Euro credit on the other hand faces higher economic and political uncertainty. Not only does it have superior credit fundamentals, its underperformance in 2018 due to contagion from the Italian budget saga could lead to spread outperformance in 2019, especially in a scenario where the ECB extends monetary policy support.

Across the rating spectrum, HY should continue to outperform IG amid rising interest rates, due to its higher spread carry and shorter duration. The risk to this call is a protracted risk-off episode that drives government debt yields lower, boosting IG returns.

Exhibit 3: Spreads set to end 2018 at wider levels than at the end of 2016

Source: Intercontinental Exchange (ICE), Bloomberg and AXA IM R&IS calculations

Looking to downgrade equities to neutral over the course of 2019

In 2019, our base case of decelerating economic activity is expected to dampen top line growth relative to recent movements. Pressures on profit margins are a key concern, induced by the rise in unit labour costs and the fading effect of the tax stimulus in the US, they limit the upside for earnings (Exhibit 4). Consensus earnings forecasts appear slightly optimistic and are likely to be revised downward going forward. Management guidance has also begun to turn cautious citing concerns mainly on the policy front.

Overall, we expect earnings per share growth to deliver close to 7% for global equities, stabilising after the solid run in 2018. On aggregate, for the asset class, we believe valuations are not a major headwind at this juncture and are close to our fair value estimates. However, we also see limited scope for re-rating with reduced excess liquidity and rising US short-term rates due to the ongoing monetary tightening internationally, and possibly higher equity risk premiums driven by higher volatility and weaker investor sentiment.

Exhibit 4: Peak margins are a key concern for 2019

Source: Bloomberg and AXA IM R&IS calculations

We expect returns to be primarily driven by earnings growth considering the limited scope for a re-rating of valuations. In our cross asset allocation, we look to neutralise our positioning in global equities over the course of 2019, while continuing to prefer the United States over the Eurozone in our regional allocation. Political risks in Europe continue to weigh on the region’s equity markets while the banking sector remains under pressure as the yield curve fails to steepen along with muted economic momentum. We continue to track the corporate leverage situation in the US, which has meaningfully shifted over recent years, especially in the small cap universe. On the equity style front, the key question remains whether we see a mean reversion in structural divergence in value versus growth stocks in 2019.


Table of contents:

Executive summary 

  Eurozone outlook
  US outlook
  China outlook
  Japan outlook
  UK outlook
  Emerging markets
  Investment strategy



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