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Battening down the hatches 

Barometer
December 2018

Pictet Asset Management Strategy Unit

With the outlook for the global economy darkening a shade and liquidity conditions less than buoyant, riskier asset classes face an uphill struggle. 

01

Asset allocation: chips off the table

As 2018 draws to a close, there are many reasons for investors to tread carefully. Even though the US Federal Reserve chairman Jerome Powell made an unexpectedly dovish speech at the end of the month, potential stumbling blocks for financial markets abound. These include global trade tensions, Brexit, and Italy-inspired political upheaval in the euro zone. 

At the same time, the outlook for the global economy has darkened a shade, liquidity conditions continue to deteriorate and technical indicators are flashing red for many of the major asset classes. 

There are, of course, attractive investment opportunities still to be found, particularly after recent market turbulence. But, on balance, we think that the mix of uncertainty about the future and the tough conditions in the present merit a reduction in our exposure to riskier asset classes. We have therefore decided to reduce our equity stance to neutral and upgrade bonds to neutral.

monthly asset allocation grid
December 2018
Pictet asset allocation December grid
Source: Pictet Asset Management

Our business cycle readings have deteriorated for the US, Japan and Switzerland compared to last month. Leading indicators now show neutral or negative economic scores in virtually all regions. The only exception is China, where government stimulus is starting to filter through into more infrastructure spending and retail sales excluding cars are holding up well.

For the world as a whole though, business sentiment is at its gloomiest in two years, according IHS Markit data. The latest surveys imply the world economy will grow by less than 3 per cent next year, which suggests that consensus expectations will have to be scaled back.

slowing growth

World PMI 

World PMI chart
*34 manufacturing PMIs GDP weighted. Source: Thomson Reuters Datastream. Data covering period 01.10.2016-31.10.2018. 
 

A particular area of concern is the US housing sector, where activity has slowed markedly, price inflation peaked in the first quarter and 30-year mortgage rates have risen to 5 per cent from a low of under 3.5 per cent in 2016.

Partly to blame is a sharp contraction in liquidity. Over the past 12 months, the volume of credit made available by central and private banks as proportion of nominal GDP in the US, China, the euro zone Japan and UK is has halved to a level equivalent to just 8.3 per cent1.

For the first time since the global financial crisis, we expect that these five major central banks will, on aggregate, be selling down their holdings of the financial assets they accumulated under quantitative easing. And this will have a negative impact on the business cycle, particularly in the US, in the more interest-rate sensitive sectors of the economy, including business investment.

Technical indicators add to the case for caution, with the picture for cyclical equity sectors particularly uninspiring. Meanwhile gold – a traditional safe haven – looks heavily oversold, which could accentuate any price gains should investors become more risk averse.

Valuations support our neutral stance on global equities, which now look neither especially expensive nor cheap: the 12-month forward price-to-earnings ratio for the benchmark MSCI ACWI index is at what we consider to be a reasonable 13.7. Bonds remain expensive in aggregate, although that hides pockets of value, particularly in emerging market local debt.

02

Equity sectors and regions: don't expect a Christmas hurrah

It is looking unlikely that the global equity market will enjoy a strong year-end rally. Even after the most recent correction, which took world stocks down by a further 1 per cent in November, we remain cautious. Slowing economic growth and trade tensions between China and the US do not bode well for the equity market.

The outlook for corporate profits doesn’t look bright either. Companies across all industries are experiencing the biggest number of earnings downgrades in two years. Growth in global corporate profits is likely to halve to 7 per cent next year from this year’s 13 per cent.

We keep our underweight stance on the US. We expect corporate profits growth in the US to fall to 7 per cent from this year’s 23 per cent, the biggest drop among all the major regions.

Japan continues to be our favourite region. Although the economy is suffering a slowdown in export growth, its equity market still trades at an attractive valuation. Japanese companies’ low corporate leverage is another plus: on average they have a net debt/EBIDTA ratio of 1.48 per cent, lower than their developed market counterparts.

We remain neutral on the euro zone. While we’ve seen a marginal improvement in the region’s economy and equity valuations here are relatively cheap, worries over Italy’s debt could potentially escalate in the coming months to hit business activity.

Emerging market (EM) stocks are attractive, though. Economic activity in developing countries is holding up better than in their advanced counterparts, thanks mainly to a resilient China.

EM stocks are attractively priced – largely because emerging currencies are trading well below our estimated fair value. Growing expectations that the Fed may slow the pace of monetary tightening next year – which could lead to a weaker dollar – should also help EM markets.

What is more, many investors are still cautious about emerging markets overall – which we see as a bullish contrarian indicator.

more correction to come for economically-sensitive stocks?

Performance of cyclical relative to defensive stocks, indexed

Cyclicals vs defensives chart
Source: Thomson Reuters Datastream. Data covering period 27.11.1985 - 28.11.2018

When it comes to equity sectors, we are downgrading material and energy stocks amid volatility in commodity markets.

We have also scaled back our overweight stance on health care, partly on the grounds of expensive valuations as well as uncertainty over regulation in the US, where drug pricing could be one of the few areas of agreement between Democrats and Republicans in a split legislature.

We see defensive stocks outperforming their cyclical counterparts. Consumer discretionary and IT are trading at unusually high valuations, leaving them vulnerable to an economic slowdown. For this reason, we have upgraded utilities to neutral.

03

Fixed income and currencies: looking up for EM local debt

A dovish speech from Fed chair Powell has fuelled expectations that the central bank will temper its monetary tightening in the coming months, which should support EM local currency bonds, particularly if it takes some of the steam out of a rampant dollar. As a result, we maintain our overweight position in this fixed income asset class.

EM local currency debt has shown signs of life during the past couple of months after struggling through the first half of the year. Having been weighed down by a strong dollar, US-China trade tensions and ructions in a handful of markets – not least Turkey and Argentina – investors are rediscovering the asset class’s potential. A halt or even a slowdown in the Fed’s monetary tightening programme would potentially create an environment under which EM bonds could recover a bigger slice of this year’s losses. Even after a recent bounce, the leading EM local debt index – the JPM GBI-EM Global Diversified Index – is down 12 per cent in dollar terms from April’s highs.

looking up for local

JPM GBI-EM Global Diversified Composite Index, total return. Reindexed to 27.11.17 = 100.

EM bonds chart
Source: Thomson Reuters Datastream. Data from 27.11.17 to 27.11.18 

We’ve trimmed our US Treasury position slightly as the post-Powell euphoria pushed 10-year US government bond yields below 3 per cent for the first time since September. Markets are now only pricing in a single 25 basis point rate hike for 2019 and one this December. By contrast, back in October the market was expecting the December hike as well as two and a half more in 2019. We have also tended to use Treasury bonds as a hedge against some of our other positions. That becomes less important now that we’ve decided to turn neutral on both bonds and equities.

German government bonds, which have returned 2.2 per cent year to date, are now the most expensive asset class on our valuation matrix, overtaking European corporate bonds from a few months ago. We consequently remain underweight German government debt. We are also maintaining our strategic bearish stance on credit due to a tightening of liquidity conditions, a peak in earnings growth and deteriorating credit quality. What is more, corporate default rates also appear to be bottoming out.

Meanwhile, we retain our overweight on gold, which has performed well this year and remains a good hedge against any surprise upsurge in inflation. The combination of weaker economic momentum, a dovish turn by the Fed and still rising inflationary pressures is a big support for the precious metal. 

A peak in US lead indicators coupled with a more dovish Fed should also provide a ceiling to the dollar, which is trading at very elevated levels, some 15 per cent above fair value on our models.

04

Global markets overview: oil slips

Commodity markets took centre stage in November, with oil prices suffering their biggest monthly slide in over a decade as Saudi Arabia raised its output to a level not seen in 80 years despite a slowdown in world  economic growth. The Kingdom reportedly increased its daily output to 11.2 million barrels a day, up from 10.8 million, bowing to calls from the US to lower prices. 

As investors grew concerned at the prospect of oversupply, Brent crude fell by more than a fifth, collapsing to below USD60 from USD85 at the end of October.

CRUDE PLUNGE
Brent crude spot price, USD/barrel
Oil price chart
Source: Thomson Reuters Datastream. Data covering period 26.11.2013-27.11.2018.

Elsewhere, riskier asset classes were in the ascendancy, paring some of the heavy losses suffered the previous month. Investors were buoyed by unexpectedly dovish comments from the Fed, while hopes that the US and China might call a truce in their trade dispute provided an additional boost to stocks.

Emerging market stocks, bonds and currencies delivered the strongest returns. The MSCI Emerging Market equity index ended up 4 per cent while its local currency fixed income counterpart rose by more than 2.5 per cent. The Indian Rupee, the South African Rand and the Turkish lira rallied against the dollar, notching up gains of at least 6 per cent.

Developed world assets didn’t fare as well as their emerging market counterparts, but still ended in the black. The MSCI World Index was up some 1.5 per cent in local currency terms while sovereign bonds also gained, led by a Fed-inspired rally in US Treasuries. The yield on the benchmark 10-year note briefly dropped below 3 per cent.

Despite the November rally, emerging market assets are set to end 2018 deeply in the red. Year-to-date, emerging market stocks are down 12 per cent while emerging market local currency bonds are nursing losses of about 7 per cent.

05

In brief

barometer december 2018

Asset allocation

We move both equities and bonds back to neutral from, respectively, overweight and underweight.

Equity regions and sectors

We continue to favour Japanese and emerging market stocks. The US remains the most unattractive market. 

Fixed income and currencies

We slightly trim our position on US Treasury bonds to a single overweight.