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Geopolitical risks, shifting central bank stances, Goldilocks looking fragile. The factors to consider when allocating assets are in constant flux. One asset allocation theme that should hold good longer-term is the transition to a lower carbon economy.
Since early May, geopolitical risks have once again been at the forefront of investor concerns, and tweets, declarations, threats and summit meetings have caused erratic movements in the financial markets. While we will not try to forecast the next twists on the trade front, we have forged a fundamental view on the issue, and events since the first skirmishes in March 2018 have so far validated the framework for our analysis.
On the one hand, objecting to China’s hegemony in world trade can be justified by China’s growing weight in global manufacturing. On the other hand, while it is not a case of calling into question more than 40 years of reorganising global production, the de-globalisation theme is likely to persist over the next few years. Periods of high and low tension are likely to follow in response to comments from the various parties.
It should be remembered that denouncing exporting countries is a typical characteristic of the style of US leaders: in the 1980s and 1990s, Japan was regarded as the wrecker of the local automobile industry and fingers were pointed repeatedly. Now formally standing for re-election, Donald Trump took matters a step further in late May by linking trade with Mexico and illegal immigration. The threat of globalisation to a country’s most fragile population, or to those who see themselves as such, will likely remain a domestic policy challenge in most developed countries.
The position of leading central banks, particularly the US Federal Reserve, has changed since the beginning of the year and investors have welcomed this shift towards a more accommodative stance. Equity and fixed income markets have risen in tandem.
The second half of June saw positive surprises. President Mario Draghi started the ball rolling on 18 June, suggesting that the ECB was considering further monetary easing measures, potentially even a resumption of asset purchases (quantitative easing). In early June, the ECB had already indicated that interest rates would remain at their current level until the end of the first half of 2020 at least.
On 19 June, US policymakers’ conclusions were also positive for equity investors. By indicating that in the face of mounting uncertainty (trade tensions and global growth), the Fed will “act to support economic expansion,” Chair Jerome Powell endorsed the futures markets’ high expectations of a cut in key rates.
This Fed commitment matters since periods of a pause in monetary policy tightening can historically be associated with a rise in both equities (in most cases) and government bonds (see exhibit 1). The period between December 2015 and December 2016 was an exception: on 16 December 2015, Chair Janet Yellen announced the end of the zero interest rate policy that had been in place since the end of 2008 and, although it took her a year to raise rates a second time, there was no doubt that policy was being normalised, which explains the poor performance of bonds.
Source: Bloomberg and BNP Paribas Asset Management, as of 19 June 2019
Past performance can provide useful information, but tactical asset allocation decisions need to take other elements into account. Our base case economic scenario foresees moderate global growth, less dynamic than in 2017 and 2018, without excessive inflationary pressures. Domestic demand has remained strong in the US, supporting business activity.
Some financial markets reflect recession risks in a way that we believe to be excessive. In the eurozone, business surveys appear to underestimate GDP growth (0.4% in Q1). The ebbing of inflationary expectations in the markets is likely to reflect Mario Draghi’s accommodative comments in June. They have largely contributed to investors forgetting the risk of a confused political situation in Italy creating tensions with the European Commission over compliance with the Stability Pact.
In this apparently favourable environment, May’s stock market drop to us looked like a tactical opportunity to buy US and European equities. In early June, we increased our long position through the use of options. The downside (political or economic) risks are, of course, high and should not be overlooked, but they appear to be manageable, particularly on the trade front in the short term. At the same time, inflation is modest, allowing central banks to be patient.
The combination of moderate growth, low inflation, and accommodative monetary policies is known as ‘Goldilocks’, referring to the fairy tale where Goldilocks after tasting too hot a bowl of porridge and then another bowl that was too cold finally finds one that is ‘just right.’ After 10 years of extraordinary monetary policies, however, ‘Goldilocks’ looks a little fragile and risks being associated with higher volatility than, for example, in the second half of 2017.
Source: BNP Paribas Asset Management, as of 19 June 2019
China now accounts for almost one third of the world’s CO2 emissions as a result of the development model adopted by China and its industrialisation. Since 1970, GDP per capita has grown by 600% and CO2 emissions by 500%. The industrial revolution in developed countries had led to a 400% increase in GDP per capita and a 500% increase in CO2 emissions.
The new economic model that the Chinese authorities are now envisaging focuses on developing services and technology rather than traditional industry and should put China on a more balanced, and thus less polluting, path to growth. The shifts in the MSCI Emerging index’s sectoral composition show that this transition is already underway: The weight of technology, which was practically zero in 1995, now exceeds 25%, while the weight of basic materials has fallen from 25% to around 7%.
These changes reinforce the relevance of BNP Paribas Asset Management’s commitment to ESG and our strategy to focus on thematic and environmental ESG1 funds incorporating our asset allocation decisions and our goal to earn long-term sustainable returns for investors.
1 Using environmental, social and governance criteria
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