Brexit twists and turns and US-China trade negotiations over Twitter have become such regular features of the investment landscape, it has become difficult to disentangle meaningful developments from posturing and noise.
We are not naive enough to believe the Brexit chapter is closed, nor that political stability and harmony will come back to the UK parliament. However, we are venturing to say the Brexit issue no longer poses the potential systemic risk it did before.
With general elections in sight, Brexit is now a domestic issue, which will continue to generate noise and impact long-term economic prospects for the UK. However, with a no-deal Brexit out of the way for the time being, it does not threaten to abruptly shut long-established trade relationships and supply chains between the island and the European continent.
The US-China rivalry is likely to last even longer than the Brexit saga and it would be foolish to mistake the resumption of negotiations for a resolution to the trade war. However, the talks are a significant step, with both parties having agreed to move forward step-by-step, rather than attempting to solve wide-ranging issues all at once.
In the meantime, the global economic environment has not changed much, with household consumption and service sector activity sustaining low-but-positive GDP growth against the ongoing slowdown in industrial activity. Risk remains tilted to the downside and the possibility of a further slowdown is non-negligible. Nevertheless, our central scenario remains one of constructive global growth stabilisation and gradual, mild pickup next year.
The dissipation of short-term high-impact risks around Brexit and the US-China trade war could help alleviate downward pressure on business investment in the months ahead, reducing the risk of ‘extreme left tail' outcomes. This warrants a more constructive view on risky assets for the end of the year, especially in a context where central banks have maintained or even accentuated their accommodative stances. Positive global growth, accommodative monetary policy and low rates might even be enough to fuel a catch-up in demand for assets and markets that have so far taken a battering.
Adjusting for optimism
Accordingly, we raised our risk preference by one notch to a mild preference, reducing the implicit defensive bias in the portfolio equity allocation. Given extreme levels of relative valuations between defensives and cyclicals, we did not want to get caught on the wrong foot by a reversal in relative performance.
Therefore, we increased our preference for UK equities, keeping the exposure to the British pound open. We adopted a mid-cap bias, as these companies benefitted the most from the dissipation of a no-deal Brexit risk in the short term. Meanwhile, we maintained a mild preference for eurozone equities, with a preference for Germany, due to its cyclical sectorial composition. We also lowered our preference for the more defensive Japanese market to a mild disinclination.
In the fixed income space, duration remains at a mild disinclination due to low inflation and dovish central banks. In the current environment, duration can still provide a useful hedge for portfolios against the risk of a negative macro outcome.
Keeping with our increase in risk appetite, we raised our preference for high yield and hard currency emerging market debt to a mild preference and local currency emerging market debt to a mild disinclination. In the local debt bucket, we upgraded Mexico to a mild preference, as the peso is cheap, interest rate levels are attractive and inflation is on a downward path. We downgraded Turkey to a strong disinclination because of renewed geopolitical tensions, prospects of possible US sanctions and downward pressures on the Turkish lira.
We kept a mild preference for investment grade credit and inflation-linked government bonds, while nominal government bonds are still scored at a mild disinclination. The latter are expensive but continue to provide a decorrelation effect in a balanced portfolio.
Italian government bonds remain the favoured European sovereign bonds market, in the context of ECB monetary policy easing and positive relative value. US and Canadian government bonds are the other sovereign bonds market of choice, as they offer the highest protection in the event of a recession.
Regarding currencies, the heavy downside pressure which dragged the British pound to an undervalued level has now abated and warrants convergence towards fair value. The pound is therefore scored two notches higher than last month, at a mild preference.
The Japanese yen is ranked at a mild preference for its diversification characteristics in a risk-off environment, while gold remains the preferred currency alternative for diversification. The US dollar is still favoured to the euro despite the greenback's higher valuation, as it offers a better growth outlook and a positive yield differential.
Adrien Pichoud, head of total return strategies at SYZ Asset Management
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