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November 2019

Barometer: The gloom lifts a little

Central banks are opening the liquidity taps again, easing concerns over growth and corporate profits. Prospects for emerging market assets look better as a result.


Asset allocation: glimmers of light

The US Federal Reserve and the European Central Bank are again pushing on the liquidity pedal. The US and China have relented on launching salvos at each other over trade. And our leading economic indicator is showing positive glimmers.

Yes, there are still question marks over China. And Germany continues to struggle. But on balance there’s a sense that sunnier skies are opening behind the recent global gloom. Hence our decision to raise our equity allocation to neutral from underweight – accompanied by a reduction in our cash allocation.

monthly asset allocation grid
November 2019

Source: Pictet Asset Management

Our business cycle readings show that although global growth prospects remain below potential, our leading indicator points to some improvement in economic conditions in the months ahead. Much of that is thanks to some increasingly positive data from the US manufacturing and industrial sector and to the American consumer’s surprising resilience. If this month’s China-US trade talks result in a compromise – however narrow in scope – that’s likely to lift business sentiment.

A relaxation of trade conditions would be welcome for China in particular. Although its forward indicators have shown some improvement, the economy is still burdened by a decline in private investment, sluggish consumer spending and the devastation African swine fever has wrought on the country’s pork industry. Germany – which is likely to be in recession – will also be looking for good news on trade given its dependence on manufacturing and exports.

Fig 1. Leading lights

World leading economic indicator, 3m/3m annualised

World leading economic indicator, 3m/3m annualised

Source: Pictet Asset Management. Data covering period 31.01.2017 to 30.09.2019.

Global liquidity conditions are neutral for riskier asset classes. The Fed seems bent on completely reversing its quantitative tightening with its interventions in the repo market. True, it’s not officially quantitative easing. But the effect is the same. At the same time, the central bank has delivered three rate cuts.

Meanwhile, on this side of the Atlantic, the ECB has engaged in its own easing programme – a parting gift from outgoing president Mario Draghi. That’s on top of strength we see in euro zone private lending. And several emerging economies have also started cutting rates.

So far, China hasn’t followed suit. Official policy continues to squeeze the shadow banking sector, while rising inflation – a result of the porcine catastrophe – limits the central bank’s room for manoeuvre. A trade deal, however, might give it a bit more flexibility.

Our valuation indicators haven’t changed materially over the past month despite the rally in risk assets and bond market sell-off. Equities are broadly fairly priced, though within the asset class, the US remains very expensive and the UK very cheap.  And government bonds are expensive, while corporate bonds are extremely expensive.

Technical indicators are also broadly the same on last month – modestly positive for both bonds and equities and seasonality broadly neutral for both markets. Trends signals are turning negative, however, for Swiss and Japanese government bonds.


Equity sectors and regions: better prospects for EM and value stocks

Prospects for emerging market (EM) stocks are brightening again. Data showing a recent stabilisation in China’s economy, expectations for a truce in the US-China trade war and the likelihood of further US interest rate cuts are likely to support growth in emerging countries. According to our forecasts, EM economies will expand 4 per cent this year – well ahead of their developed counterparts.

EM corporations, meanwhile, are expected to increase their profits by 14 per cent next year - a figure that could be even higher if the dollar weakens further.

We have therefore upgraded emerging stocks to overweight.

In contrast, we are unenthusiastic about most developed market stocks. Our main concern is that the consensus forecast that corporate profits in the US, Europe, Switzerland and Japan will rise by some 8-9 per cent in 2020 is too optimistic.

We keep our underweight stance on the US, which is the most expensive market and where we expect 2020 corporate profits to be flat at best. We cut UK stocks to neutral as we await more clarity on the outcome of the general election and Brexit negotiations. We remain overweight in the euro zone, where ample monetary stimulus is likely to support growth.

At a time when the world economy is expanding modestly, it is, as history shows, tough for companies operating in the most cyclical industries to increase profits. Instead, the evidence is that value stocks – which trade at a lower price relative to their fundamentals – tend to outperform.

It is hardly surprising, then, that value stocks have been witnessed a revival in their fortunes in recent months, having lagged their growth counterparts for the past decade (see chart).

fig. 2 Value due a revival
Relative 12-month trailing price-to-earnings of ratio:  MSCI Value Index vs MSCI Growth Index
Equities value growth.png

Source: Refinitiv, data covering period 31.12.1974 - 30.09.2019

We expect this rotation to continue as the business cycle moves to a more mature phase. For these reasons, we have upgraded financials to overweight. European banks, whose share prices have suffered, look particularly attractive given the region's private liquidity conditions have reached a 10-year high of 4 per cent.1

We downgrade consumer discretionary – typically exposed to fluctuations in economic cycles – to underweight.

Our preference for defensive stocks remains unchanged. We are overweight both consumer staples and healthcare sectors.


Fixed income and currencies: cloudy, with silver lining in EM

The outlook for global bonds remains cloudy. Valuations are extremely high and inflation is eating into returns. Real yields are at a record low of 1.4 per cent.

Still, every cloud has a silver lining, and for fixed income markets, that’s EM bonds. 

Although the yield on EM local currency bonds hit a historic low in October, the asset class still offers the best value of all major bond markets. For a start, at 5 per cent, the yield is still much higher than elsewhere. Additionally, EM currencies look very attractive. According to our model, they are 20-25 per cent undervalued versus the dollar, and we would expect some of that gap to close in the coming year, providing an additional boost to EM bond returns.

fig. 3 a positive indicator of sentiment
Chinese 10-year bond yield, %
Chinese bond yields

Source: Refinitiv. Data from 29.10.2018 to 29.10.2019.

The outlook for EM currencies and bonds looks brighter from an economic perspective. Of the 22 emerging markets which our economics team monitors, we expect growth to be slower in 2020 than in 2019 in just four countries. This month, for instance, we have become more positive on China following stronger September data – with improvement in industrial production, construction indicators, metals output and government fixed investment – and signs of a more conciliatory tone in the trade talks with the US. Encouragingly, Chinese bond yields, which are traditionally a reliable sentiment indicator of economic growth, are on an upward trend (see chart).

Consequently we upgrade EM local currency debt to overweight, and also retain our preference for emerging market credit.

We also see potential in inflation-linked bonds, particularly in the US, where inflation expectations have yet to catch up with the hard data: US core CPI remains near a 10-year high of 2.4 per cent.

In developed market corporate debt, we are underweight across the board, concerned by the asset class’s high valuations and companies’ historically low credit ratings – the ratio of CCC-rated to B-rated companies is higher than even during the 2016 energy crisis, a particularly bad time for high yield credit.

European investment grade bonds, for example, are yielding just 0.4 per cent, even as Germany flirts with recession. This is particularly worrying at a time when global earnings growth is decelerating sharply – our models suggest flat earnings per share over the next six months.

We are neutral on US Treasuries, which we believe fairly reflect the likely path of monetary policy. While we expect no more US rate cuts in 2019, next year is more of an open question. If the economy disappoints, there is a risk that the extent of easing will exceed current expectations. A further rise in yields could present an opportunity to increase portfolio duration.

Our currency positioning is broadly defensive, with a preference for havens such as Swiss franc and gold. We also remain overweight sterling, for which the latest Brexit developments have been positive.


Global markets overview: equities marching higher

October proved a good month for risky assets. Global equities gained 3 per cent in local currency terms, as investors welcomed signs of reprieve in the US-China trade tensions and monetary stimulus measures from major central banks.

The Fed cut interest rates by a quarter of a percentage point to 1.75 per cent, monetary authorities in Japan and Canada flagged the possibility of lower rates, and the ECB continued liquidity injections. There was also easing in emerging markets, notably in Brazil.

fig. 4 scaling new heights
S&P 500 composite price index
S&P 500 composite price index

Source: Refinitiv. Data covering period 27.10.2017 to 29.10.2019.

US stocks gained about 2 per cent, with the S&P 500 index setting a fresh record high. Stronger than expected economic data from China helped emerging market equities perform better still.

The pattern of returns across equity sectors reflected a growing appetite for risk. Cyclical sectors such as technology, financials, real estate, industrials and consumer discretionary outperformed. On the flip side, defensive sectors - consumer staples and utilities - finished the month in the red.

Bonds also suffered, down 0.5 per cent globally. Developed market government debt lost ground, as did European investment grade credit – one of the most expensive sub-classes in our valuation model.

UK gilts were among the worst performers, finishing down 2 per cent as Britain managed to avoid a no-deal Brexit in October. Conversely, the political developments boosted sterling, which surged 5 per cent against the US dollar, claiming the spot of the best performing major currency in October.

The dollar’s weakness was fairly broad-based, as it seems investors closed out some of the extreme long positions in the US currency. The euro, Swiss franc, Chinese yen, Korean won, Mexican peso, Brazilian real and Russian ruble each gained more than 1 per cent. Gold also benefitted from the dollar’s downfall, climbing 2.5 per cent.


In brief

barometer november 2019

Asset allocation

We upgrade equities to neutral and trim cash to single overweight.

Equities regions and sectors

We upgrade emerging markets and financials to overweight, cutting consumer discretionary to underweight.

Fixed income and currencies

We favour emerging market local currency debt thanks to the improving economic outlook and attractive exchange rates.