By Nicolas Forest & Nadège Dufossé
The first quarter of 2016 will leave behind the bitter taste of a full-blown hangover. Despite the increased generosity of central banks, fears over global growth in recent months left financial markets in turmoil. However, despite these fears, we have identified several investment ideas likely to generate solid performances for investors.
Our first lead is related to the possible rise in inflation expectations. Right now, inflation prospects reflect neither the improvement in the economic environment nor the more accommodative stance of the central banks. In the euro zone, we have also identified undervalued assets that may provide opportunities. Finally, emerging markets are expected to continue recovering under the combined impact of the weaker dollar and more stable commodity prices.
Preparing for the return of inflation
The Fed has clearly indicated that it will take the international environment into consideration in its plan to gradually raise its funds rate, taking an inflationary risk in order to avoid undermining the economy’s vulnerable growth. And yet, despite the ultra-accommodative monetary policies adopted on both sides of the Atlantic, inflation prospects continue to decline. In Europe, inflation breakevens are flirting with their all-time lows, while inflation has finally returned in the US after years of deflation fears.
However, wore inflation has stabilised in the euro zone and has even rebounded in the US. Given the recovery in the manufacturing sector, the tension on the job market and floor-level oil prices, we may be at the dawn of a new period of rising inflation expectations. Against this backdrop, inflation-linked securities are good investment opportunities, as are some currencies such as the Norwegian krone and the Canadian dollar.
European opportunities
The euro zone economy is currently benefiting from low oil prices, a weak euro and a more accommodative fiscal policy than in recent years.
However, despite this improvement in fundamentals, the region is still facing a number of political risks, which can explain the underperformance of equities and corporate bonds. The possibility of Brexit is a major risk that has yet to be priced in by the UK equities market, while the pound sterling has priced in a Brexit probability of around 25%.
After underperforming the US equities market for months, valuations should offer an attractive entry point once the political risks have dissipated and investors refocus on fundamentals and take the ongoing European economic recovery into consideration.
In the credit space, financials offer an attractive risk/reward profile, as do European High Yield bonds. Financials have underperformed non-financials in spite of renewed risk appetite. But the fears surrounding potential systemic risk are unfounded! Capital, asset quality and liquidity have improved substantially in recent years. Even though the sector has published satisfactory results, profitability will be impacted by the combination of low interest rates/oil prices and high volatility. It’s important to be selective when it comes to business models and seize the opportunities that arise on the primary market, especially given their attractive premiums!
Emerging market recovery
After years of turbulence, emerging markets also look promising. Pressures have eased thanks to the depreciation of the US dollar and the stabilisation of commodity prices; economic surprises and earnings revisions are both headed in the right direction. Against this backdrop, emerging equities are attractive with their valuations still at historic lows based on Candriam’s cycle-corrected P/E ratios. Cumulative investment flows are near six-year lows and asset allocation strategies continue to underweight the region, despite its attractive turnaround potential.
Emerging debt is also attractive and should continue to outperform. Capital outflows have also begun to reverse for emerging bonds and, in a low yield environment, returns on debt in foreign and local currencies remain well above 5%.
At current levels, many emerging currencies are historically cheap, in the wake of the correction begun in May 2013 when the Fed first unveiled its gradual tapering programme. We are big fans of certain high-beta currencies, including commodity-linked currencies (RUB, MXN and COP), since we see oil prices likely stabilising approximately at current levels.
Nicolas Forest is global head of fixed income and Nadège Dufossé is head of asset allocation at Candriam Investors Group.
