Recession, populism and the end of quantitative easing

How AXA Investment Managers’ multi asset team are navigating the end of the cycle

As central banks around the world begin withdrawing their support and short-term political policies gather pace, the traditional end of cycle conventions are being rewritten. Serge Pizem, head of multi-asset investing at AXA Investment Managers, explains how he and his team are responding.

If you adhere to longstanding principles of investing then it’s widely accepted that there are four phases to every cycle.

First comes the growth phase, then expansion, deceleration and finally, recession.

However, when faced with the longest running cycle in history – a cycle during which vast quantities of capital have been pumped into the system by central banks – things get a little more complicated.

In a normal environment, what characterises the end of the cycle is the switch from the mature deceleration stage, towards recession.

However, while recession may be on everyone’s lips, it’s stubbornly refusing to show up in the data.

As top down investors, AXA Investment Managers’ (AXA IM) philosophy is built around examining quandaries such as this and determining where exactly we stand in the cycle.

‘As a team, we spend a lot of time trying to get that right because at each stage there is an optimal asset allocation’, explains Serge Pizem.

In Q1 2019, they are not seeing recessionary signals in their models, so believe we are still in the deceleration phase, with recession most likely two years away.

Preparing for volatility

While there is no recession signal, the team has reduced its risk exposure from where it was at the start of 2018.

This has largely been in response to more volatility as central banks withdraw their support after a decade of accommodative monetary policy.

While Pizem and his team are not trying to time the market, they are cognisant of ensuring their portfolios mitigate the impact of a maturing cycle.

‘The trick is not to be too early, but crucially, not to be too late in reducing the risk.’

To help guide this process, the team works on identifying where excesses have built up during the expansion and maturity phases of the cycle, as they are the parts of the market that will suffer the most when the cycle ends.

Excesses, Pizem explains, are found in areas that have grown the most.

‘For instance, physical real estate has gone up aggressively in many places around the world, without a major correction, and that’s where one needs to focus and look at how sound those valuations are.’

Managing the potential pitfalls of illiquidity

Being trapped in illiquid positions is another risk investors need to be especially aware of as the cycle draws to a close.

‘If you have any illiquid assets, you’re in bad shape. If you’re a pension fund you have the benefit of being able to hold to maturity, you will have to suffer the mark to market impact, but at the end of the day the funds are there. In contrast, we manage open-ended funds, so if our clients wanted their money back, we would be a forced seller, and that’s where, as a mutual fund manager, we have to be very careful.’

As a consequence of the Federal Reserve (Fed) providing very cheap financing, many US companies have substantially increased their balance sheets and are now much more indebted than in previous cycles. This is another area where Pizem sees liquidity risks brewing.

‘This is a situation that could be problematic when, and if, we go into a recession, especially as there is a lot of refinancing that needs to be done in the next three years.’

Consequently, AXA IM’s multi-asset team are particularly careful in the crossover credit space – i.e. bonds that have a slightly higher yield than the overall investment grade space with slightly better credit rating than the broader high yield market.

Post crisis investors flocked to this area of the bond market as it was seen as a relative safe haven with attractive yields just a notch below investment grade in the credit spectrum.

‘Triple-B investment grade bonds are now at an all-time high in terms of the volume that they represent. However, there isn’t the liquidity there used to be in the market, so as we go down into the last phase of the cycle that might be a problem,’ explains Pizem.

Meanwhile, across the globe in emerging markets a sharp correction has already taken place, here Pizem and his team are gradually increasing their exposure across both bonds and equities to take advantage of attractive valuations.

‘Emerging markets are priced for a full recession in 2019. But if the dollar – and that’s the key – stabilises or weakens, there is a high probability that we’ll have an upward movement in emerging markets.’

The rise of populism

In January 2019, Brazil presented an opportunity when President Jair Bolsonaro took office. While headlines have focused on his populist leanings, Pizem and his team are encouraged that Bolsonaro has brought a good economic team with him.

‘They have strong backgrounds, so we are counting on them to propose some solid economic policies,’ he said.

Populism has been a running theme in recent years. Brexit and the election of Donald Trump in the US has provided legitimacy to the movement in Western democracies, and it’s a theme Pizem believes will shape markets for some time to come.

‘The emergence of populism is a big difference between this and previous cycles, especially now it’s a worldwide phenomenon.’

He argues that while we have experienced pockets of populism it is more widespread today and more clearly identified as a threat.

As their intention is to appease voters, populist policies tend to be short-termist. The clearest example being the US increasing its already large deficit when the economy is at full employment and doesn’t need it.

‘We now have de-globalisation coming in. Trade issues and increases in tariffs – the old recipes that we all know are to the detriment of long-term growth – are returning.’

Populism, Pizem says, is helping to create much more volatility and increasing the potential for a downward correction in markets.

To respond to this, the AXA IM multi asset team continually test their convictions with data and regularly review their scenarios with in-house economists and external experts to ensure they assess where we stand in the cycle.

‘Only once we have a firm view on this, can we ensure our asset allocation is optimal for the environment’ concludes Pizem.