1 OUR CONVICTIONS MONTHLY INFO US administration imposes additional 10% tariff on $200 billion in Chinese imports MONTHLY REPORT - EXPOSURE in % THE ART OF THE TRADE WAR 90% In The Art of War, Master Sun shares his three strategic precepts for achieving an extremely ambitious objective: the intelligent prosecution of FIXED UNDER EXPO INCOME successful war. The strategy is simple, and relies on a rational analysis of 85 M M the various aspects of a war. First, you have to assess the economic and moral cost of the war, bearing in mind that the acme of any conflict is a 100% victory without bloodshed. Next, you need to identify your comparative M UNDER advantage so you can exploit it and destabilise your adversary, as this STOCK EXPO stratagem allows you to gradually strip him of any desire to fight. Lastly, M and this is the key to success, you need to know and understand your adversary. With its mastery of these three precepts, China has successfully and skilfully navigated a world of runaway globalisation, using WTO rules to its advantage to create beneficial imbalances in international trade. But the IN THIS REPORT MACROECONOMIC ENVIRONMENT TRADE WAR: THE ESCALATION CONTINUES IN THE BACKGROUND Julien Daire arrival of the unpredictable Donald Trump shook China s understanding of Head of Fixed Income and credit management the world and how it works. In fact, the US president's unconventional style and obvious stalling tactics have put its strategy at risk and forced it to Bastien Drut Senior Strategist take a step back before acting. But its seeming passivity should not mask CASH MANAGEMENT the hegemonic desires of an empire suffering from a lack of recognition. WHAT ARE YOUR MONEY-MARKET PRODUCT After cancelling the negotiations planned for end-september, China has shown more signs of rapprochement with Russia, be they economic or military. For its part, by finalising USMCA, the United States has blocked STRATEGIES? Anne-Charlotte Ducos Money-market and credit manager any opportunities for circumvention by China. While we do not anticipate a military drift in our trade war scenario (15%), we are concerned that NEXT MEETING escalating tensions could affect key sectors such as automotive. At the same time, the Italian budget and the risk of rating agency downgrades could unduly destabilise the markets (15%). Lastly, in this increasingly anxiety-provoking world, we remain convinced that the situation can, or rather will, improve, which is why our central scenario of continued robust momentum in global growth remains our dominant scenario at 70%. OVER EXPO OVER EXPO 18 OCT 2018 cpr-asset-management CPR Asset Management For more information, please contact: LUNCH CONFERENCE CPR AM LAUNCHES ITS NEW THEMATIC FUND CPR AM's teams are pleased to give you a preview of their new thematic equity innovation.. This document is provided for informational purposes and meant exclusively for journalists and press and media professionals. Information is provided for the sole purpose of providing journalists and press and media professionals with a broad overview, regardless of the use they make thereof, which is under their exclusive editorial responsibility and for which CPR Asset Management declines all liability. This document is not to be construed as an advertisement or an offer to buy or sell and does not incur the liability of CPR Asset Management. Past performances are not constant over time and are therefore not a reliable indicator of future performances.
2 BOND MARKET KEY INDICATORS WILL INFLATION BOUNCE BACK? MYTH OR REALITY The most recent headline and core inflation publications were somewhat disappointing in the United States and Europe. These disappointments did not prompt investors to protect themselves against a return of inflation. However, monetary policies remain accommodative, economic growth is strong and wage pressures are emerging due to the improvement in the labour market, at a time when oil prices are rising and a trade war is encouraging the return of inflation. Inflation has already risen (from 0% in 2015 in the United States and Europe to 2.7% and 2.1% today, respectively) and the risks now seem mostly to lie in the continuation of this increase. For now, inflation expectations do not reflect investors concerns about this risk. These expectations have not taken off this year in Europe (1.34% for the euro 10-year inflation breakeven versus 1.30% at the beginning of the year) or in the United States (2.13% for the US 10- year inflation breakeven versus 2.0% at the beginning of 2018). At current levels, inflation breakeven strategies offer a real opportunity by serving as a tool for diversification within an asset allocation with lower volatility than traditional bond strategies. They also offer protection against an ongoing rise in rates and in inflation, by preventing this ongoing rebound in inflation from turning into a headache for unprotected investors. INFLATION EXPECTATIONS (%) MONTHLY REPORT EQUITY MARKET ANALYSIS EMERGING MARKETS: HAS THE STORM PASSED? Emerging market equities have been suffering as whole for several months against the backdrop of the escalation of the trade war between the United States and China, but mostly because of high dollar debt situations in certain countries, such as Turkey, Indonesia and South Africa, if not a mix of the two in Turkey s case. It was the debt indices that were the most volatile this summer when the equity indices slipped more slowly towards negative performances. Against the backdrop of dollar appreciation and higher long- and short-term rates in the United States, emerging countries will continue to suffer for a few more weeks until the results of the midterm elections in the United States in early November and the Fed s next rate hike in December. Nevertheless, current equity index levels are attractive entry points in the medium term for the following reasons: - prices have corrected much more sharply than earnings estimates - the United States ultimately has more to lose than to gain in a trade war - oil prices are rising The storm has partially passed, but its tail continues to hover over emerging countries, symbolised by short-term selling flows. A gradual initiation of positions in the coming weeks for a two- or three-year horizon is still a good idea!. EARNINGS GROWTH IN 2018 REMAINS HIGHER RELATIVE TO THE BEGINNING OF THE YEAR Sources : Bloomberg / CPR AM Sources : CPR AM - Factset This document has not been drafted in compliance with the regulatory requirements aiming at promoting the independence of financial analysis or research. CPRAM
3 MARKET SCENARIOS OVERVIEW ON OUR MARKET SCENARIOS AT THE END OF SEPTEMBER % CENTRAL SCENARIO: GLOBAL GROWTH REMAINS STRONG The situation is overall unchanged. Activity levels remain strong in the United States. Inflation stabilises above target. The first tariff increases do not yet affect activity. Key rates: rise in United States (2.50%), no change in Japan (0%) and the eurozone (0%). Long-term rates: rise in United States (3.30%) and the eurozone (0.75%), no change in Japan (0.15%). Equities: +2.5% in the United States, +5% in Japan and the eurozone, +7.5% in emerging Asia, +5.0% in emerging Latin America. Rise in EUR/USD to PROBA CENTRAL SCENARIO 70% 15% 1ST ALTERNATIVE SCENARIO: TENSIONS ON TRADE WORSEN IN KEY SECTORS The trade war continues to escalate. It now affects key sectors in the global economy: technology and the automotive industry. Measures to restrict Chinese export volumes are mentioned. Key rates: rise in United States (2.50%), no change in Japan (0%) and the eurozone (0%). Long-term rates: fall in United States (2.90%), Japan (0.10%) and the eurozone (0.40%). Equities: -10% in emerging countries, -7.50% in Japan and the eurozone and -5% in the United States. Fall in EUR/USD to ST ALTERNATIVE SCENARIO 15% 15% 2ND ALTERNATIVE SCENARIO: STRONG POLITICAL TENSION IN EUROPE DUE TO ITALY AND A HARD BREXIT Political risk in Italy remains a major concern in Europe with the preparation of the 2019 budget and the risk of a collapse in the leading coalition. Despite discussions between the United Kingdom and the European Union, fears of a hard Brexit are mounting. Key rates: rise in United States (2.50%), no change in Japan (0%) and the eurozone (0%). Long-term rates: No change in the United States (3.10%). Slight fall in Japan (0.10%) and decline in the eurozone (0.25%). Equities: 0% in the United States and emerging countries, 2.5% in Japan, -10% in Europe. 2 ND ALTERNATIVE SCENARIO 15% Fall in EUR/USD to PERFORMANCE AS OF PAST PERFORMANCE IS NO GUIDE TO FUTURE RETURNS. SCENARIO FORECASTS in % Since the within 1 year within 5 years Level from CENTRAL 70 % proba. ALTERNATIVE 1 15 % proba. ALTERNATIVE 2 15 % proba. United States 1.34% % 1.76 % % 8.69 % 1.68 % % 2.23 % % % 3.60 % 7.89 % % % % 2.00 % 3.06 % Key rate 10-year interest rate High Yield US Euro/dollar S&P % % % 3.10 % Europe 0.36 % 0.52 % % 0.33 % 1.15 % % 0.33 % % % % 0.53 % key rate 10-year interest rate High Yield Europe DJ EuroStoxx % % 0.40 % % 0.25 % Japan 5.57 % % % Nikkei % % Source CPR AM Publication manager : Gilles Cutaya Editor en chief: Arnaud Faller Photo credit: Shutterstock.com Next edition: November 2018 CPR ASSET MANAGEMENT, limited company with a capital of Portfolio management company authorised by the AMF n GP RCS Paris. 90 boulevard Pasteur, Paris France Tél. :
4 MACROECONOMIC ENVIRONMENT Julien Daire Head of Fixed Income and credit management Bastien Drut Senior Strategist WHAT CAN BE SAID ABOUT THE ECONOMIC SITUATION IN EUROPE AND THE UNITED STATES? The US economy is doing very well, thanks to the tax reform adopted in December, which boosted household consumption and corporate profits. This facilitates hiring and encourages. The leading indicators are very well oriented and suggest that the growth trend is currently around 3%. However, it is important to note that this acceleration of growth comes at the cost of a worsening in public finances. The widening of the deficit ($ 890 bn over the last 12 months) has been mainly financed by the issuance of short-dated US Treasury securities (T-bills). In the eurozone, economic growth has decelerated from impressive levels in 2017 to around 2%, which is still one percentage point above potential growth. One of the positive elements is the acceleration of wages, which has reached its highest rate in years and could stimulate household consumption. Conditions in the labor market continue to improve. Although it has recently declined slightly, consumer confidence remains close to its highest levels in the last 30 years. WHAT ARE THE PROSPECTS FOR FIXED-INCOME MARKETS IN THE CURRENT CONTEXT? The ECB will stop its asset purchase program in December. In the monetary policy normalization strategy, the next step will be to raise the key rates. For now, the ECB indicates that this will not happen until the summer of However, the market remains in our opinion far too pessimistic about the ability of the ECB to raise rates in the coming years. In the end, the ECB should start raising its key rates when the Fed should pause. AGAINST THIS BACKDROP, WHAT WILL DO THE CENTRAL BANKS? The good performance of the US economy will allow the Fed to continue to raise rates on a gradual basis (one rate hike per quarter) over the coming quarters. This being said, the Fed has already raised its key rates by 200bps since the beginning of its tightening cycle (December 2015) and the real estate sector is already losing momentum due to the rise in mortgage rates. As far as FOMC members are concerned, concerns are now about when the Fed will have to stop its tightening cycle. This document has not been drafted in compliance with the regulatory requirements aiming at promoting the independence of financial analysis or research. CPRAM
5 MACROECONOMIC ENVIRONMENT WHAT ARE THE INVESTMENT THEMES TO FAVOR IN THE FIXED-INCOME MARKETS? The shift in the monetary cycle between the Fed and the ECB makes it interesting to look at long US duration and short European duration strategies. Whatever the maturities (2 years, 5 years, 10 years) yield spreads between the United States and Germany are at a 30-year high. In addition, the theme of inflation remains relevant. Improvements in labor markets, in the United States as well as in Europe, but also upward pressure on oil prices mean that long breakeven strategies still remain attractive and protective in the case inflation surprises on the upside. In the credit market, in a context of growth above potential in Europe, we are still favoring the High Yield segment for its attractive carry. We remain cautious on the Investment Grade segment. This asset class seems to us more vulnerable to the end of QE in Europe and the risk of a rise in rates especially as the market anticipates very little rate hikes in the 2 coming years. In this environment, we remain positioned on maturities of less than 5 years which offers the best risk-return ratio. WHAT ARE THE RISKS THAT COULD CHANGE THE GAME? For the fixed-income markets, the main risk for our central scenario concerns Italian politics. The formation of the new Italian government has raised fears about public debt sustainability and in particular about Italy s credit rating. Each rise in the Italian spread has coincided with a sharp decline in German yields and an exacerbation of political risk (for example triggered by the convening of new elections) could delay the rise in German long-term rates. As a result, we are not positioning ourselves in negative short-term sensitivity and we hedge the interest rate risk through swaps in order not to suffer from swap spreads widening. In addition, we are putting in place optional protection strategies on rates and credit. For the moment, the trade war between the United States and China has had little impact on the economy and on the fixed-income markets. However, an intensification of tensions over some crucial sectors (automotive) would trigger a deceleration in the world economy and would push central banks to adopt a more cautious approach. In this context, a long position on US rates or simply a long position in the interest rate spread between the US and Europe seems protective. This document has not been drafted in compliance with the regulatory requirements aiming at promoting the independence of financial analysis or research. CPRAM
6 CASH MANAGEMENT Anne-Charlotte Ducos Money-market and credit manager WHAT ARE YOUR MONEY-MARKET PRODUCT STRATEGIES? TAKING STOCK OF 2018 SO FAR, WHAT HAVE THE MAJOR TRENDS BEEN IN THE SHORT-TERM MARKET? The ECB policy transition period and the extremely low levels of return were the two main risk factors identified for Informed investors have nevertheless been faced with a market that is hard to read. The outcome of the elections in Italy and the surprise coalition between two anti-system parties have been a catalyst for the spread widening since May. In a market where volatility has returned and returns are at an all-time low, one would expect specific risk to replace the technical factors that have driven the bond market for the last three years. The short end, which had held up very well until now, has also undergone a repricing (see Chart 1). These factors have therefore all played a role in the general spread widening and in the decline in performance in Chart 2 MERRILL 1-3-YEAR BOND SPREADS Chart 1 BANK SPREADS VS EONIA Source CPR AM 3 month 6 month 12 month IN YOUR OPINION, WHAT ARE THE MAIN CHALLENGES IN THE MONTHS AHEAD? We will be busy with a number of well-identified issues in the next few months. Source CPR AM The new money-market regulation will take effect on 1 January The funds have, on the whole, already incorporated most of the changes required in terms of the new liquidity and ratios. The implementation of stress tests, the liability control requirement and, first and foremost, the end of the amortised cost valuation method for securities maturing in less than three months are the main challenges of this reform for management companies. Money-market funds will have to be included in one of the following categories: VNAV (variable net asset value) funds; CNAV (constant net asset value) funds, which are required to invest 99.5% of their assets in government debt; and, This document has not been drafted in compliance with the regulatory requirements aiming at promoting the independence of financial analysis or research. CPRAM
7 CASH MANAGEMENT to a lesser extent, LVNAV (low-volatility net asset value) funds. They must also be classified as standard or short term. After the end of the QE anticipated for December 2018 comes the rate normalisation expected in second-half It is difficult to say what the pace of the normalisation will be at the moment, given how forcefully Mario Draghi has argued for caution and patience in this regard. The market currently expects an initial rate hike at the end of 2019 but the Eonia forward curve is much lower than it was at the beginning of the year. New interest rate benchmarks are expected to be introduced in the last quarter of 2019 in the eurozone. The contribution scandals during the financial crisis and the significant decline in transaction volumes prompted European regulators to redefine the benchmark selection criteria, which must be robust, reliable and resistant. ESTER (Euro Short-Term Rate) will therefore replace the current Eonia as of 1 January 2020 to meet these criteria. The implementation and impact of this project remain relatively unclear for now and will depend, in particular, on the transition period between the old and new indicators. Lastly, we will move into the TLTRO II repayment period, which will concern nearly 750 billion by March 2021, the majority of which is due in July The issue of replacing these lines of credit granted by the ECB (at -0.40% over a four-year period) with traditional refinancing will no doubt change the balance of power, which has been extremely advantageous for banks in recent years, and provide opportunities for investors. IN LIGHT OF THE UPCOMING CHANGES, WHAT IS YOUR STRATEGY FOR MONEY-MARKET FUNDS? As mentioned earlier, 2019 will be an intense year for our asset class. As such, we will of course need to adapt our management approach to the changing environment. For money-market funds, we are adopting a defensive strategy with modified duration near zero and credit durations of close to nine months (versus a maximum of 12 months) to adjust to widening spread trends. We expect returns to gradually normalise in the coming months. We therefore favour 12-month s and negotiable debt security vehicles which are more resilient than 24-month bonds. For short-term bond funds, we favour the high-yield segment, which offers a more protective carry than the -grade class. We are hedged against interest rates as we believe the rate hike pricing in the Eonia curve is too defensive (Eonia to return to positive territory at end- 2020). We will wait for the Italian risk to fade and for more favourable momentum in core CPI before taking a negative modified duration position. Lastly, breakeven strategies continue to have potential in a long-term approach. To conclude, the upcoming transition phase carries some risks and will involve carefully managing the negative mark-to-market as credit premiums make a comeback. Nevertheless, the rate hikes and spread normalisation are ultimately good news for the asset class and we therefore expect performances to improve over This document has not been drafted in compliance with the regulatory requirements aiming at promoting the independence of financial analysis or research. CPRAM