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monthly asset allocation views

March 2019

Barometer: The growth gap favours EM assets

After rallying powerfully since the start of the year riskier assets don't look particularly attractive - apart from those in emerging markets.


Asset allocation: a delicate equilibrium

The world has found a delicate state of equilibrium. On the down side, economic growth is faltering, and valuations for virtually all asset classes have become more expensive since the start of the year. And then there are also the unresolved matters of Brexit and the US-China trade dispute.

On the up side, however, liquidity conditions have improved and China is starting to reap the benefits of monetary and fiscal stimulus.

Although it is difficult to be enthusiastic about developed market assets in general – we remain neutral global bonds and stocks – defensive equities, where earnings are holding up well, and emerging markets (EM), which are growing faster than their rich world counterparts, both look promising.

monthly asset allocation grid
March 2019
PAMs Barometer monthly asset allocation grid

Source: Pictet Asset Management

Our business cycle indicators show emerging economies are outpacing their developed counterparts. Historically, this has been supportive for all EM asset classes, and particularly for currencies.

Based on our leading indicators, the growth gap between the emerging and developed world – at nearly 5 percentage points – is at its highest in half a decade. The disparity reflects a steep drop in export orders among developed economies such as Germany, which appear to be suffering disproportionately from ongoing trade tensions. EMs – and particularly China – have also been hit to an extent. Indeed, our models show that the tariffs unveiled by the US to-date should shave around 0.5 percentage points off Chinese GDP growth. But Beijing authorities have acted fast to counterbalance this with stimulus. We estimate their measures so far – which include infrastructure projects as well as income and corporate tax cuts – will have a positive impact of 1 percentage point on growth, spread over last year and this.

Our liquidity scores confirm that China’s recent stimulus measures are starting to pay off. The country is on track to reach simulative liquidity conditions this quarter, boosted by strong growth in private lending. Our global monetary impulse indicators are strengthening, becoming more supportive of economic growth and riskier assets.  G3 excess liquidity – the difference between the rate of increase in money supply and nominal GDP growth – has turned positive and is now at its highest level in nearly two years. This bodes well for corporate price-to-earnings ratios (see chart). 
G3 excess liquidity and % change in  global equities’ trailing PE ratio, 6-month
G3 excess liquidity and % change in  global equities’ trailing PE ratio

Source: Thomson Reuters Datastream, Pictet Asset Management. Excess liquidity calculated as G3 broad money minus value of domestic industrial production growth over the past 6 months. Data covering period 30.04.2000-31.01.2019.

The risk is that investors are too complacent. While central banks have proved responsive to signs of economic weakness, we believe this could prove a temporary shift in tone. In our view, the market’s interest rate projections underestimate the likelihood of US Federal Reserve hiking interest rates once more before the year end. Fed futures are pricing in only a 2 per cent chance of such a move; in October it was 98 per cent.

Valuations add a note of caution following strong market gains in early 2019. Virtually every asset class in our model is more expensive now than a month ago, with global equities among the priciest. This is worrying given that corporate earnings growth peaked in 2018, at 15 per cent, and that analysts have been reducing their expectations for future profits. However, we see early signs of stabilisation in earnings forecasts, which should prove positive.

Technicals paint a mixed picture. Although trends are generally positive for equities, in many regions – including the US and Europe – this is offset by some excessively bullish investor positioning in certain stocks. For bonds, meanwhile, upbeat momentum and breadth – the degree to which the recent rally has been broad-based – are counterbalanced by strongly negative seasonal trends. Taken together, these signals back our decision to remain neutral on both equities and bonds at a global level.


Equity sectors and regions: looking pricey apart from EM

After a storming start to the year, equities have largely recovered losses sustained during the panic that gripped the markets in the fourth quarter of 2018. That leaves the MSCI All Country World Index trading near the top of a range that’s held during the past year and leaves us questioning its potential for further gains, especially as corporate earnings growth prospects weaken (see chart).

The biggest risk for US equities in particular is that the recent softening of corporate earnings expectations continues. In October, the market’s forecast for US earnings per share growth was 11 per cent for the current year. The consensus growth estimate has since fallen to 4 per cent, though it should stabilise around there unless US GDP growth decelerates significantly through the rest of the year. For these reasons, we remain underweight US stocks. 

US equities may be relatively expensive, but there is great value in the UK and China. The UK’s dividend yield of 4.5 per cent is broadly the same as it was in the wake of the Lehman Brothers bankruptcy in 2008 – too attractive to ignore even as the Brexit debacle continues. A cheap pound makes British shares look even better value. Meanwhile, China’s market is policy driven and policy right now is pumping up liquidity provision and fiscal spending, boosting Chinese and EM stocks. 

Where economic growth leads, profits follow

World leading index (6-month lead) vs world corporate profits growth, % change on year

World leading index vs world corporate profits growth

Source: Datastream, Pictet Asset Management. Data covering period 31.12.2013 to 27.02.2019. Pictet Asset Management World Leading Index plus G3 PPI, 6-month lead; MSCI ACWI constituents' global corporate profits, year on year change, adjusted for foreign exchange.


Indeed, EM assets are in a sweet spot. EM currencies are the cheapest they’ve been in at least two decades relative to the US dollar. Our sentiment indicators suggest investors remain lightly invested in EM equities despite a rally that leaves them up almost 10 per cent year to date. Fundamentals for EM economies remain sound as most countries follow prudent fiscal and monetary policies. And China’s reflationary policies should boost exports and commodities. Chinese and Russian shares are particularly attractive while the Brazilian market is looking very expensive after its 40 per cent rally since last summer’s trough.

Elsewhere, we have decided to raise our defensive allocation by lifting utilities to overweight from neutral. Regulated industries like utilities that have fairly constant demand over the cycle tend to have bond-like characteristics and thus outperform at times when more growth-oriented equities struggle. By the same token, we’ve maintained our overweight positions in health care and consumer staples.

By contrast, we’ve reduced industrials to neutral from overweight in response to ongoing trade disputes. While the market seems to believe that the US-China standoff is over, we’re not so sure. The market is pricing in a positive conclusion to the talks between the two but it’s a leap to assume that current negotiations will result in a comprehensive agreement anytime soon. 


Fixed income and currencies: bright spot in EM

Debt issued by emerging economies is a bright spot in the fixed income market.

Resilient economic growth, low inflation and a stable to weaker US dollar should combine to support both EM local currency and dollar-denominated debt in the coming months.

We are therefore upgrading EM hard currency debt to overweight, and maintain our positive view on local currency bonds.

Despite the US-China trade spat triggering a slowdown in global exports and a deterioration in business sentiment, emerging economies are faring better than their developed counterparts – thanks in part to China’s monetary and fiscal stimulus.

This is reflected in a widening of the gap between our leading indicators for developing and industrialised economies to levels not seen since 2013 (see chart).

further ahead
Difference in economic growth implied by leading indicator, percentage points, emerging and developed economies
Difference in leading indicator growth

Source: Thomson Reuters Datastream. Data covering period 31.12.2000 – 01.01.2019.

A higher EM-DM growth gap tends to be beneficial for EM hard currency debt.

Data spanning the past 25 years show that yield spreads on EM dollar bonds have typically declined whenever this economic dynamic has held sway. That’s significant as falling credit spreads are an increasingly important source of return for the asset class at a time when a sharp drop in the volatility of the US bond market means that gains from duration – those that flow from any further falls in longer-dated US Treasury yields – are likely to be low.

A favourable inflation picture also supports developing market bonds. Inflation in EM economies stands at 3.1 per cent, near a record low. The difference between emerging and developed inflation is at the narrowest since 2000.1

A solid economic outlook for the developing world also supports our view that EM currencies – which are trading some 25 per cent below what we consider to be a fair value – should build on their recent gains against the dollar in the coming months, boosting returns from emerging local currency debt.

In developed markets, we struggle to find viable investments, except for US Treasuries, in which we remain overweight. Not only has the Fed paused its three-year campaign of interest rate hikes, the central bank also appears open to reducing its portfolio asset sales later this year. Valuations for US bonds also remain attractive relative to other fixed income securities, according to our scorecard.

We have reduced US investment grade bonds to underweight. Developed market credit looks unattractive to us at a time when corporate earnings growth has peaked and credit ratings are deteriorating.

We maintain our overweight stance on gold – which acts as a hedge against global economic uncertainty, geopolitical risks and a weaker US dollar.The World Economic Policy Uncertainty Index, which tracks global geopolitical risks has recently hit an all-time high.2


Global markets overview: buoyant (for now)

Global stock markets rallied in February, adding to the previous month’s gains, as investors were buoyed by the growing prospect of a resolution to the trade dispute between China and the US and a likely pause in the Fed’s monetary tightening campaign.

The MSCI World Index ended up by more than 3 per cent, bringing its year-to-date return to about 11 per cent, a remarkable rebound from its near-collapse into bear market territory in December and its strongest start to the year since 1987.

For the second month in a row every industry sector in the S&P 500 US stock index was in the black – with economically-sensitive stocks such as technology and materials leading the market higher.

china rally
Shanghai Shenzhen CSI 300 price index
Shanghai Shenzhen CSI 300 price index

Source: Thomson Reuters Datasteam. Data covering period 27.02.2018-26.02.2019.

Likely to have further boosted US stocks was news of upcoming corporate share buybacks. Tech giant Cisco, rail group Union Pacific and Bank of America authorised buybacks totalling more than USD20 billion each for this year.

Chinese stocks remained firmly in rally mode as authorities in Beijing stepped up monetary stimulus in a bid to encourage private lending. By the end of February, the Shanghai Shenzen CSI 300 index was up almost 30 per cent since the end of 2018 (see chart).

With the exception of China, emerging market stocks were laggards over the month, with the MSCI EM Index rising just 0.2 per cent, held back by a sharp fall in in Latin American markets.

Global bonds ended down, with yields on both US Treasuries and German Bunds nudging higher. Italian government debt received a shot in the arm towards the end of the month after rating agency Fitch decided against lowering its credit rating on the country.

In the currency markets, the dollar gained some ground against most major currencies including the Japanese yen, the euro and the Swiss franc. The British pound bucked that trend however, rising more than 1 per cent as the prospect of the UK crashing out of the EU with no deal receded.


In brief

barometer march 2019

Asset allocation

We retain a neutral stance on equities, bond and cash at a global level.

Equity regions and sectors

We raise utilities to overweight and cut industrials to neutral.

Fixed income and currencies

We downgrade US investment grade bonds to underweight. Emerging markets remain one of the most attractive fixed income asset class.