In the second article in a new series, Pascal Blanque and Amin Rajan argue that quantitative easing will continue to distort asset prices for the foreseeable future despite the rise of populist politics
Donald Trump’s presidential election victory in the US is a seismic event with far-reaching ramifications. The fiscal stimulus he has promised could be a game-changer for asset allocation in the near term. But nothing can be taken for granted as of now. Much will depend on the size, shape and timing of the economic package. The bigger it is, the harder it will be to service the perilously high US debt mountain as new deficit spending drives up interest rates for all borrowers.
In the near term, therefore, central banks’ ultra-loose monetary policies will remain a key driver of returns and asset valuations will continue to remain distorted, according to the latest Amundi/CREATE Research Annual Pension Survey*.
The ‘don’t fight the Fed’ refrain has pushed investors up the risk curve in an agnostic search for value. Certain classes of equities will be cheap because bonds remain expensive. The figure presents pension plans’ investment preferences over the next three years, distinguishing between most favoured (top half of the figure) and least favoured (bottom half).
However, our survey respondents remain deeply worried about the rise of nationalism marked by Britain’s vote to exit the EU and America’s election of an overtly nationalist administration. Will President Trump implement what Candidate Trump promised? Or will his programme be toned down by the constraints of power?
After all, history shows that populist policies often fail under their own contradictions. And markets are poor predictors of their impacts until they are faced with them. But one thing is for sure: the dream combination of high returns and low volatility of the past six years is history. As a result, pension investors’ preferences reflect four investment themes that would be most conducive to value creation at a time when bonds and equities valuations defy logic (see Perspectives from a Dutch pension plan) and the global debt python is constricting growth everywhere.
Key investment themes
The first theme reflects the search for yield. Global equities and high-quality equities will be favoured for their excess yield over bonds. Further expansion in earning multiples will be acceptable because these asset classes remain the biggest beneficiary of fresh stimulus from central banks in China, Europe and Japan. In contrast, markets in Europe and the US have narrowed; their momentum has weakened with fewer – mainly defence and pharma – stocks now powering their rise. The likely fiscal stimulus in the US could change all that, if it also boosts the global economy.
The second theme favours off-market bespoke investments such as infrastructure, alternative credit and private equity – all delivering uncorrelated absolute returns in excess of equities. They are also perceived as being less sensitive to rate rises on account of their in-built floating-rate structure. Real estate allocations will be directed towards value-added and opportunistic categories, since prime and core assets are deemed over-valued.
The third theme treats investing as a relative value game, while the QE tide continues to lift all boats. This will favour under-valued, under-researched and under-loved assets in four areas – investment grade bonds, high yield bonds and emerging market equities and bonds. Arguably, emerging markets are coming into favour not because of their renewed dynamism but because they offer better relative returns – in the near term.
The final theme cautions against over-capitalising on the negative interest rates of sovereign bonds in parts of Europe. Yes, the rates may sink even further into negative territory and generate windfall gains. Reflecting desperation on the part of central banks, negative rates sound like a one-way bet but they rely on the ‘greater fool’ theory of investing.
Central banks cannot go on defying market gravity with paper money that has no asset anchor to reduce financial instability and moral hazard. Hence, net new money into sovereign debt is likely to be limited. Another reason is that rates are likely to rise in the US to fund the new deficit spending. The longest bull market in bonds in history may be coming to an end.
Pascal Blanqué is CIO of Amundi Asset Management and Amin Rajan is CEO of CREATE-Research
*Expecting the Unexpected: How Pension Plans are Adapting to a Post Brexit World
Perspectives from a Dutch pension fund
“The strong dual rally in bonds and equities to record levels in July 2016 was a rare phenomenon, as was the mass dual sell-off in September, both telling contradictory stories.
“Declining yield – and even negative yield in Europe and Japan – presage recession, rising risks and a fall in capital expenditure, if the history of the past 50 years is any guide. On the other hand, booming equity markets imply higher growth, rising earnings and strong corporate spending. This seeming disconnect is explained by two idiosyncrasies in today’s financial markets.
“First, many of the purchasers of sovereign bonds are compelled by regulators to buy them at any price. Pension plans in some EU jurisdictions are obliged to offset long-term liabilities with assets of similar duration.
“Likewise, banks buy bonds to comply with the new rules that govern their risk profile.
“Most of all, central banks themselves have become the biggest buyers of bonds as part of the quantitative easing (QE) programmes. On the supply side, governments have not been issuing bonds in large volumes. In the face of artificial excess demand, bond markets are like broken crystal balls with little predictive powers.
“Second, on the equities side, unconventional monetary policies have taken valuations to heights well above their historical norms. High stock prices are not evidence of a healthy economy. Rather, they reflect the fact that there are too few opportunities for productive investment as companies grapple with the secular stagnation scenario, while the global debt mountain shows no sign of shrinking.
“The question uppermost in the minds of investors worldwide is whether corporate earnings can rise in a modest growth world. It is hard to tell.”