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September 2019

Barometer: Expectations dashed

As central banks aren't likely to deliver the volume of stimulus markets are hoping for we remain underweight equities.


Asset allocation: central banks set to disappoint investors

The global economy continues to count the cost of the trade war but most investors seem convinced that central banks will ride to the rescue with aggressive monetary stimulus. We don’t share their optimism.

Our leading indicators point to subdued global growth in the coming months as uncertainty from trade tensions hits industrial production and business sentiment, especially in developed economies.

What is more, corporate earnings growth should grind to a halt this year after a stellar 2018.

Although we expect central banks to ease monetary policy to arrest the economic slowdown, policymakers are unlikely to deliver the sort of stimulus the market is currently discounting.

Against this background, we remain underweight equities. At the same time, we have more reasons to keep our cautious stance on bonds now that this year’s rally – the strongest in 20 years -- has pushed the yield on nearly a third of the global bond universe below zero1. We maintain our overweight in cash.

monthly asset allocation grid
September 2019

Source: Pictet Asset Management

Our business cycle analysis shows global economic growth is likely to slow to an annualised 2 per cent this year from 3.4 per cent in 2018, with developed economies suffering most. Business sentiment, as measured by the Purchasing Managers Index, has fallen below the critical 50 threshold, the lowest since 2012, while industrial production in developed economies is contracting for the first time since 2016.

While the outlook for export-oriented sectors is gloomy, consumers are not tightening their purse strings yet. Globally, consumer sentiment is at a record high, supported by a strong labour market and falling mortgage rates. For these reasons, we think the probability of a global recession is lower than consensus estimates of around 30-40 per cent.

Fig. 1 Weaker 

World Leading Indicator*

AA world leading index.png

*Weighted average of 39 countries' leading indicators, %3m/3m annualised. Source: Refinitiv, CEIC. Data covering period 01.07.2017 – 31.07.2019

Liquidity indicators support our cautious stance on stocks. Even though the US Federal Reserve cut interest rates in July, the volume of new liquidity provided by global monetary authorities has contracted at a rate of 0.5 per cent in the past six months. This is primarily down to developments in China, where the central bank is implementing measures to reduce corporate indebtedness. We think monetary conditions will ease somewhat in the coming months, given that the Fed is expected to cut interest rates again and the European Central Bank is set to announce fresh bond buying worth EUR600 billion later this month. Still, we think investor expectations that the world’s central banks would provide a monetary stimulus of as much as USD1.5 trillion over the next year are wide of the mark2.

Our valuation model shows that some equity markets, notably the US and Switzerland, continue to be expensive. A decline in capital spending and uncertainty over the outcome of the trade war have weighed on corporate earnings, with the US Bureau of Economic Analysis cutting its 2018 corporate profit calculations by 8.3 per cent, wiping USD188 billion from the previous tally.

Europe, in contrast, is becoming attractive as corporate earnings stabilise and bond yields fall. The equity risk premium – an estimate of how much return stocks provides over the risk-free rate –  has in Germany shot up above 9 percentage points for the first time ever. Valuations for emerging markets are also attractive, especially in Asia, where the price-earnings ratio is a modest 11.  Japan has shown a remarkable resilience in the face of a rising yen; given the market's favourable valuation, there is the potential for Japanese stocks to rise by as to 20 per cent over the medium term.

Industry sectors most sensitive to the economy – industrials and IT stocks – continue to look expensive, trading at a premium of over 12 per cent relative to their defensive counterparts such as consumer staples and pharmaceuticals.

Our technical indicators are neutral for stocks, but are flashing red for those defensive assets that have rallied strongly in recent months, such as the yen and government bonds. 


Equity sectors and regions: Europe to eclipse US

With the US-China trade dispute boiling over again, it’s becoming ever harder to be optimistic about prospects for the economy and corporate earnings as rising tariffs and threats of further trade barriers weigh on business and consumers worldwide.  Throw in additional uncertainty about Brexit and the outlook remains gloomy for the rest of this year, which is why we remain underweight global equities. As Fig. 2 shows, corporation profit margins worldwide are trailing analyst expectations by a considerable margin. 

US stocks look particularly unattractive relative to other equity markets in this environment. The benchmark S&P 500 index is only a few percentage points off its all-time highs but US recession indicators are flashing red – the yield curve has inverted while, for first time since the global financial crisis, dividend yields on stocks are higher than those on 30-year Treasury bonds. 

Analyst have cut their forecasts for US profits by the most in three years. The consensus is now looking for 2.4 per cent profit growth this year, compared to 7.7 per cent expected at the start of the year, according to FactSet. A recent dip in stock buybacks is another worrying sign for US equity investors, given that companies' repurchases of their own shares during the past decade accounted for around 20 per cent of the market’s returns and a third of the US market’s outperformance over its European counterpart, according to our calculations. 

Fig. 2 margin decline

MSCI All Country World net corporate margins (IBES), percent

Equities margins.png

Horizontal lines represent forecasts for 2019, 2020, 2021. Source: Refinitiv and IBES. Data from 30.01.2004 to 31.07.2019.

But there are bright spots in the equity market. Within our regional allocation, we remain overweight European equities. Germany may be in technical recession, but Europe’s leading indicators have been improving over the past six months thanks to more positive momentum in France and Spain. At the same time, a fresh round of stimulus from the ECB should help. And it’s also worth noting that the German equity risk premium (see asset allocation section for how we define the ERP) is at an all-time high of 9 per cent.

At the same time, the Japanese market has been resilient, notwithstanding a strong yen. Valuations are very cheap, showing an upside of up to 20 per cent according to our calculations. The UK also offers good value, particularly for international investors. Sterling is cheap, valuations are attractive and a substantial proportion of corporate Britain’s earnings are generated abroad. In addition, the market's 5 per cent plus dividend yield offers some insulation from potential market volatility.

Economic prospects for emerging markets have been hurt by the trade war, but that’s being mitigated by interest rate cuts. Asia is a bright spot as some peripheral markets benefit from China’s woes – the Sino-US trade war is beginning to divert business to other Asian exporters.

Concerned about the impact of the trade war, investors have shifted back towards defensive stocks. Consumer staples and healthcare have done well – we continue to be overweight both – while small cap equities have significantly underperformed. So far US consumers have been resilient, helped by wage growth and falling mortgage rates, which has kept the US economy out of recession. But that’s unlikely to last.


Fixed income and currencies: safety in short supply

During periods when the world economy is slowing, it generally makes sense to increase allocations to defensive assets such as government bonds. The trouble is, with bond yields having fallen precipitously in recent months, what would normally be considered safe now looks risky. By the end of August, the yield offered by the JPMorgan Government Bond Index had reached 0.73 per cent – a record low - while the 30-year US Treasury was yielding just under 2 per cent. Equally remarkable, the global volume of bonds offering negative yields hit a record USD15.5 trillion. 

Some would argue that these valuations are justified by the dovish shift in central bank rhetoric. Our view is that market expectations for additional monetary stimulus go beyond what policymakers will ultimately deliver. As our liquidity analysis shows [see asset allocation section], the gap between the current and market-implied volume of monetary stimulus – measured as a percentage of GDP – has never been wider, which means the market is set up for disappointment.

Fig. 3 yield shrinkage

JP Morgan GBI-EM Composite Index bond yield, %


Source: Refinitiv. Data from 25.08.2009 to 27.08.2019.

Valuations reinforce our underweight to neutral stance on most government bond markets: US Treasuries, for example, are yielding 200 basis points below what our model suggests is fair value – the widest discrepancy we’ve ever seen. 

Such has been the strength of the bond market rally that valuations for an asset class we’ve long considered cheap relative to its fundamentals – emerging market (EM) local currency debt – are now also beginning to look hard to justify over the near term. True, compared to their developed market counterparts, EM bonds offer an attractive real yield of 3 per cent. But with our leading economic indicators laying bare the negative impact of the US-China trade dispute on the developing world, we believe that emerging market currencies in particular might weaken over the near term. Because of these concerns, we have shifted our stance on the asset class from overweight to neutral.

When it comes to currency positioning, we retain our overweight stance in both the Swiss franc and gold – both should do well in a period characterised by geopolitical upheaval and a deterioration in global economic conditions.


Global markets overview: equities shudder, bonds bloom

August was the story of weak equities and strong bonds as investors reacted to an escalation of trade tensions between China and the US and positioned for the next wave of monetary stimulus amid signs of economic weakness around the world.

Equities lost some 2 per cent in local currency terms during the month, paring year-to-date gains for the MSCI World index to 15 per cent. Bonds surged by 2.9 per cent. Concerns about economic prospects hammered oil prices, which ended down more than 8 per cent on the month, while the risk-off move sent gold up 7 per cent for nearly a 20 per cent gain on the year so far.

With the exception of the Swiss market, which managed modest gains in local currency terms, equity markets were down around the world. Unsurprisingly, markets with the greatest sensitivity to China – emerging markets and Japan in particular – suffered some of the biggest losses. Meanwhile, the UK market was battered by fears of political chaos as the deadline for Brexit approaches and a 'no deal' divorce seems on the cards. Among sectors, energy and financials were two of the biggest losers, down some 6 per cent and 5 per cent respectively.

Fig. 4 a lower low

US and German 10-year bond yields, %

Markets 0919.png

Source: Refinitiv. Data covering period 26.08.2016 – 27.08.2019

Where equities suffered, fixed income blossomed. In the case of developed sovereign markets, this meant ever more bonds with negative yields – to total some USD17 trillion now.

US Treasuries were big winners, up some 3 per cent, boosted by expectations the Fed will ramp up its interest rate cutting programme and by the fact that they’re among the very few major developed market sovereign securities to offer positive nominal yields.

Investors pumped money into US corporate bonds, helping the asset class deliver its  best monthly return in more than a decade, with the investment grade part of the market up 3 per cent on the month and a near 14 per cent gain on the start of the year. 

Emerging market local bonds were big losers after EM currencies suffered their worst August against the dollar in 22 years, according to Bloomberg. Argentina’s crisis sent the peso spiralling lower, while China’s renminbi suffered its biggest fall in 25 years.


In brief

barometer september 2019

Asset allocation

The global economy is decelerating, albeit at a slower pace. We keep our underweight stance in equities and bonds, preferring cash.

Equity regions and sectors

A gloomy outlook for corporate profits keeps us underweight in equities. 

Fixed income and currencies 

We cut our emerging market local currency debt to neutral from overweight after yields fall sharply.