Asset allocation: priced for perfection
Global equity markets have raced to all-time highs as investors have bet that central banks around the world will open the monetary taps to arrest an economic slowdown.
However, we don’t think economic conditions justify the amount of stimulus financial markets have discounted. While a recent deterioration in economic data suggests that world growth will come in at a below-potential at 2.2 per cent this year, a slowdown of this magnitude doesn't warrant an aggressive easing of monetary policy.
For these reasons, we remain cautious on equities – and have therefore kept our underweight stance on the asset class. It’s hard to be positive on bonds either, at a time when a record USD13 trillion of global debt is yielding below zero. We maintain our overweight in cash.
Our business cycle analysis shows the global economy is experiencing a broad-based slowdown, with export-sensitive industrial and manufacturing sectors in particular continuing to come under pressure thanks to disruptions in global trade.Nowhere has this been more apparent than in the US. That said, consumer demand is resilient and labour markets remain tight. We expect the US Federal Reserve to ease monetary policy a little more following its July 25 basis point rate cute, but to limit itself to a more modest insurance policy than financial markets are discounting.
Market expectations for an additional 100 basis points of rate reductions are too aggressive.
The outlook for the euro zone economy is more positive. On a three-month rolling basis, the region’s leading indicator has risen for four months in a row, thanks to improvement in industrial production in France and Italy, better consumer sentiment and tighter labour markets.
In emerging markets, meanwhile, China’s economy posted its slowest growth in 27 years in the second quarter, yet its service sector has performed relatively well. But overall, growth in the emerging world remains relatively healthy.
Our liquidity indicators suggest taking a cautious stance on risky assets. According to our model, the current price-earnings (P/E) ratio of the S&P 500 index implies the world’s central banks are going to deliver cash injections of as much as USD1.8 trillion this year – way above the annual average of USD1.2 trillion since the 2008 financial crisis. Such a stimulus would require a simultaneous monetary easing across the US, euro zone Japan and China - a scenario we consider unlikely.
Excess liquidity of three major economies – which we calculate as the difference between the rate of increase in money supply and nominal GDP growth - has likely peaked at around current levels of 3.6 per cent (see chart), which should put downward pressure on P/E multiples over the near term.
Our valuation model indicates equities are neither expensive nor cheap at a global level. Within regions, however, the US market still is the most expensive as equities there trade at a premium of 30 per cent to world stocks on a cyclically-adjusted P/E basis. In contrast, Japanese and UK stocks remain cheap relative to global stocks.
Bonds continue to be eye-wateringly expensive, however, with real yields on global debt - as measured by the JPMorgan Government Bond Index - falling to a record low of minus 1 per cent. Within fixed income, emerging local currency debt looks good value, particularly as the developing world currencies are undervalued versus the dollar by as much as 25 per cent.
Our technical indicators suggest than neither equities nor bonds are a 'buy' at this point. Curiously, the recent rally in equities has been accompanied by only very modest flows into mutual equity funds. That said, speculative positioning in stocks among professional investors looks excessively bullish, with asset manager net holdings in S&P 500 futures at elevated levels.