Union Investment returns to neutral risk strategy
Hedge position closed out
Risk positioning goes back up to level 3 (RoRo meter)
During its regular meeting in June, the Union Investment Committee (UIC) closed out the hedge position that it had established ahead of the G20 summit. The risk positioning has thus been raised to level 3 on the RoRo meter again, while the model portfolio is now slightly more opportunity-oriented. The reasons for this decision were, firstly, the expectation of expansionary monetary policy measures in the weeks and months ahead and, secondly, the recent detente in the trade dispute. Although no breakthrough was achieved at the G20 summit in Osaka, the US and China announced that they were restarting bilateral negotiations. In the UIC’s view, the mood music from the summit can be interpreted as an easing of tensions. This can also be seen from Trump’s statement that he is reconsidering the sanctions imposed on Chinese tech company Huawei. However, the trade dispute could become an issue for the capital markets again at any time, not least because of the US election campaign.
This calmer environment, combined with the prospect of more expansionary monetary policy at the major central banks, is providing support for risk assets. However, not all (sub-) asset classes are feeling the effects of this support in equal measure. The UIC therefore believes that it is better to opt for carefully selected exposures rather than a broad allocation across risk assets.
Economic environment remains weak
The broader economy has not bounced back. This can be seen not only in external leading indicators (PMIs, ifo Business Climate Index, ISM) but also in Union Investment’s own leading indicators (ULI, ELI, CLI). The growth rate for 2019 as a whole is expected to be slower than the rate for 2018 in almost every major economic region of the world.
For the US, Union Investment’s economists are forecasting 2.5 per cent in 2019 and just 1.6 per cent in 2020. The eurozone is also likely to see its growth rate slow to around 1 per cent (or lower).
In other words, the UIC views the prospects for growth as weak and diminishing. Nonetheless, it does not anticipate a recession. The positive situation in terms of employment and consumer spending – which are both trailing economic indicators – should provide momentum going forward, as will the monetary policy stimulus recently decided upon.
Monetary policy: loosening from late summer onwards
Nearly all the leading central banks have recently made it clear that they will switch their monetary policy back to expansionary mode if needed. They are concerned about falling inflation expectations on the back of the weak economy. The first lowering of US interest rates – by 50 basis points – is expected in September. This is likely to be followed by further cuts of 25 basis points in January and March 2020. In July, the European Central Bank (ECB) will probably adjust its forward guidance towards a symmetrical formulation of the interest-rate outlook insofar as it maintains interest rates at or below their current level, before lowering its key rates by 10 basis points each in September and, at the same time, announcing a system of graduated interest rates for the currently negative deposit rate from 2020 onwards. If the Federal Reserve reduces its benchmark rates later on in the year, we anticipate that all three of the ECB’s key rates will fall by a further 25 basis points in December.
Charts of the month: Fed fund rate cuts in 2019 priced in; trade dispute has not yet led to Inflation
Underweighting of equities neutralised, focus on spread products in the fixed-income asset class
Carry remains in focus despite more risk-averse positioning
As interest rates will remain firmly at a low level due to the central banks’ policy decisions, the environment for fixed-income investments continues to be generally favourable. Yields on safe government bonds, such as German Bunds and US Treasuries, are expected to drop a little bit more. Spread segments will probably remain in demand too, especially as the hunt for returns is likely to drive investors towards these sub-asset classes even more. Against this backdrop, the UIC is maintaining its overweight position in investment-grade corporate bonds, even though their yields have fallen sharply in recent months. The committee has also decided on an overweighting of hard-currency government bonds from emerging markets (EMs), which are expected to benefit from the Fed’s anticipated monetary policy stimulus and the easing of the trade dispute. Moreover, many EM central banks raised their benchmark rates last year (partly in order to stabilise their currencies) and are now themselves in a position to loosen the monetary policy reins again.
Neutral positioning in industrial and EM equities
Most corporates in industrialised countries have healthy profit levels, whereas companies in emerging markets have relatively poor profit momentum. Although the equity markets saw a lot of movement in recent weeks due to hopes that monetary policy would be loosened, there is still a little upside price potential. The upcoming reporting season will reveal how the weak economy and trade disputes have impacted on companies’ results. Given this mixed picture, the UIC has adopted a neutral position for equities from both developed and emerging markets.
Neutral weighting for commodities again
In the commodities asset class, the Union Investment Committee (UIC) neutralised the existing overweighting of energy on 10 July 2019.
This decision was made in light of recent developments in the oil market. The anticipated restrictions in the supply of crude oil have now materialised, with US sanctions resulting in reduced output from Iran and Venezuela. Moreover, the OPEC(+) countries have extended their voluntary production cuts until the end of the first quarter of 2020. At the same time, however, the first cracks are appearing in the agreement between Saudi Arabia and Russia. Despite the inverted futures curve (backwardation), global inventory levels have risen in recent months. This is primarily attributable to soft demand resulting from the state of the economy, and comes despite seasonal support (‘driving season’ in the US). The leading indicators remain weak, which is a sign that economic conditions will remain challenging. Demand is therefore unlikely to pick up for the time being. China was the only market with strong import growth in the first half of 2019, but Union Investment’s sector experts mainly attribute this to the one-off effects of new refineries coming on stream and oil inventories being increased for strategic reasons. These effects are likely to diminish in the second half of this year.
Since the escalation of tensions in the Middle East, the geopolitical risk premium has been around US$ 5–6 per barrel. These are not really expected to ease, i.e. the oil price will remain supported in this regard. Overall, however, the consideration of a geopolitical risk premium and a reduction in supply on the one hand and a weak level of demand on the other can now only point to a neutral risk/reward profile. Based on this analysis, the UIC is neutralising its exposure in this asset class in favour of cash.
Return to the baseline allocation for currencies
The long US vs. short EM currency position, which was entered into as a hedge, will not be needed in the weeks ahead due to the latest ceasefire in the trade dispute. Moreover, EM currencies are likely to benefit from the change in the tone of monetary policy, particularly at the Fed.
Convexity in the convertible bond market remains high
The upturn in the equity markets has also resulted in a rise in the convertible bond market in recent weeks, particularly in the US. As valuation levels have gone up, volatility has fallen sharply in all regions. Overall, the convertible bond market continues to exhibit a high degree of convexity with equity sensitivity of just under 47 per cent. There have been a number of new issues in the US and Europe. Those from the US were particularly well received by the market.
Our portfolio holdings
Unless otherwise noted, all Information and illustrations are as at 2 July 2019.