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Barometer: More pain to come

June 2019

Pictet Asset Management Strategy Unit

Fresh trade tensions raise concerns about prospects for both the global economy and equity markets.

01

Asset allocation: stocks set for another slide

The escalation of trade tensions between the US and China has intensified concerns about the strength of the global economy and corporate earnings. 

If prospects for global equity markets looked unfavourable before US President Donald Trump’s latest salvo in the trade battle, then they are even more discouraging now. We therefore retain our defensive asset allocation stance: underweight on stocks, neutral on bonds and overweight cash.

monthly asset allocation grid

June 2019

June asset allocation grid
Source: Pictet Asset Management

In recent weeks, the US raised tariffs on USD200 billion of Chinese goods to 25 per cent from 10 per cent, prompting Beijing to retaliate with a similar move. Washington is now mulling higher duties for another USD300 billion of goods. 

Our analysis shows that, if implemented, the cumulative impact of these tariff increases will cut some 0.2-0.3 percentage points from world GDP growth this year. That’s a sizeable amount which doesn’t even take into account any secondary effects that might ripple through the global value chain.

What is particularly concerning is that this hit comes at a time when the global economy is already stuttering. Our business cycle indicators show economic conditions deteriorated in many parts of the world last month, including China, which suffered an abrupt slowdown in April. The economic boost from Beijing’s stimulus measures appears to have faded in recent weeks and renewed trade tensions do not bode well for the coming months. 

That said, emerging markets generally remain on a much stronger economic footing than their developed peers. And China still has plenty of stimulus at its disposal, both fiscal and monetary. 

global struggles
Pictet AM world leading index, 3m/3m growth, %
Pictet AM world leading index
Source: Pictet Asset Management. Data covering period 01.04.2017 - 01.04.2019

Indeed, China is one of the few countries where our liquidity indicators are positive. The flow of credit across the economy is improving and there are some signs that small and medium-sized companies are finding it easier to access bank lending. In the developed world, however, liquidity conditions aren't especially encouraging for riskier assets as central banks continue to shrink their balance sheets. From this perspective, emerging market (EM) assets look more attractive relative to their developed counterparts. 

Our valuation models paint the same picture. EM currencies remain deeply undervalued – by as much as 20 per cent relative to the dollar – while EM local currency debt is easily the cheapest of all fixed income asset classes.

More broadly, world stocks are fairly valued according to our model, trading at a price-to-earnings ratio of around 15 times and a dividend yield of 2.9 per cent. Still, earnings prospects are uninspiring. Corporate profit growth can be expected to slow further in the coming months, with our model pointing to 3 per cent increase in profits this year versus the consensus view of 7 per cent. Corporate profit margins also remain under pressure. 

The technical indicators we monitor, meanwhile, show that seasonality has turned deeply negative for equities across the board, ahead of what is traditionally a volatile summer period. 

02

Equity sectors and regions: US stocks under a cloud

What the equity markets gave to investors in April, they took away in May. And with a trade deal between the US and China unlikely to be struck anytime soon, the market’s recent slump looks likely to worsen. 

US shares look particularly vulnerable. The American economy is slowing and company earnings are set to weaken, notwithstanding a surprisingly good set of first quarter results. Analysts have been shaving their profit expectations for the remainder of 2019, forecasting an overall 3 per cent rise in US corporate earnings against a 3.3 per cent forecast at the start of the latest earnings season.

The US market looks even less attractive once its relatively high valuation and its disproportionate weighting towards cyclical sectors are taken into account. It is now more weighted towards cyclical stocks than any other major market, bar Japan, and for the first time ever is more exposed to economically-sensitive sectors than emerging markets. We consequently remain underweight US equities.

high intensity it
MSCI all country world index IT sector realtive to all country world index, in dollars, rebased
Tech sector relative performance chart
Source: MSCI, Refinitiv. Data covering period 02.06.2017 - 27.05.2019

By contrast, UK shares, battered by Brexit worries, look good value, not least because companies in the leading FTSE 100 index by and large generate their revenues outside their home country. A cheap currency, low valuations and the fact that the economy has so far managed to weather the political storms are reasons for maintaining an overweight on UK equities.

We aren't especially attracted to stocks that are heavily geared to the economic cycle. Within the MSCI All Country equity index, cyclical stock sectors trading at a premium of around 17 per cent relative to their defensive counterparts, above the long-term average of 10 per cent. On the other hand, autos and bank stocks are lagging and trading at book value, which is to say 50 per cent below the wider market.

Investors have long been complacent about the trade war’s potential impact on technology stocks (see chart). They’re suffering for it now. The blacklisting of Chinese telecoms giant Huawei by President Trump’s administration raises the spectre of a new technological cold war and underscores how vulnerable companies in the sector are to sudden restrictions – all the way along the global supply chain. US semiconductors stocks are down 15 per cent from their peak and are back to the level of a year ago.

Separately, we’ve taken the opportunity to take profits on recent gains in utilities, which we have downgraded to neutral from an overweight position.

03

Fixed income and currencies: EM debt to hit its stride

Even with escalating trade tensions weighing on risky assets, it is hard to be enthusiastic about bonds. With yields on global government debt having fallen to 15-month lows, defensive fixed income securities look expensive. 

Still, there are some attractive investments. EM local currency debt, for example, continues to offer potential for solid gains. 

Despite a recent recovery, EM currencies trade at well below their fair value versus the dollar. Their appreciation is likely to continue in the coming months, thanks to a favourable economic backdrop. Economic growth across EM regions continues to outpace that of industrialised countries; the gap between leading indicators in the developing and developing world remains wide. 

We are also overweight EM hard currency debt as the developing world’s relative economic strength will help narrow such bonds' yield spreads over US Treasuries.

look out below
German 10 year government bond yield, %
German government bond yield chart
Source: Refinitiv Datastream. Data covering period 26.05.2014 - 27.05.2019

EM bonds recorded their eighth consecutive month of inflows in April, attracting USD24 billion of capital, according to the Institute of International Finance.

In developed markets, we remain overweight US Treasuries. Although the Eurodollar futures curve is already discounting the possibility of more than one interest rate cut this year, Treasuries remain a cost effective insurance policy should economic conditions deteriorate further. 

In Europe, German bunds remain the most unattractive bond asset class with their benchmark 10-year yield having hit a record low.

We downgrade UK gilts to underweight. Despite Brexit-related political and economic uncertainty, UK unemployment is at a 44-year low, wages are growing at their fastest pace in a decade and consumer spending remains resilient. While the Bank of England is unlikely to raise interest rates this year, investors may be too relaxed about the prospect of monetary tightening over the coming year. What is more, gilts are expensive according to our valuation model.

We are underweight credit – both investment grade and high yield bonds. Corporate bonds look too expensive at a time when the trade war is weighing on economic growth and investor sentiment is deteriorating.

In currencies, we remain neutral in all major currencies. We maintain our overweight stance on gold – which is a good hedge in times of economic uncertainty.

04

Global markets overview: a flight to safety

May was a cruel month for equity investors as the intensification of the global trade dispute sent stocks tumbling. President Donald Trump’s salvos against China and Mexico in his rolling trade wars fed concerns that the global economy will struggle this year and filtered through to asset markets.

The MSCI World index lost some 6 per cent on the month in local currency terms, putting a significant dent in the first quarter’s rally. The global equity market is now up a shade under 9 per cent since the start of the year. Unsurprisingly, growth worries hammered commodities, particularly crude – the wider complex lost 8.2 per cent on the month, with oil down nearly 13 per cent. The IT sector took a hit too, losing around 8 per cent after the US administration took aim at Huawei, undermining the Chinese company’s multitude of global suppliers.

trading tensions
Shanghai Shenzen CSI 300 price index
Chinese shares chart
Source: Refinitiv Datastream. Data covering period 26.05.2017 - 27.05.2019

What was bad for stocks, was good for defensive assets. Sovereign bonds gained 1.8 per cent on the month in local currency terms, while gold gained 1.3 per cent. US bonds saw a particularly strong performance, up 2.5 per cent on the month. Japanese government bonds performed modestly well in local currency terms, up 0.8 per cent on the month, but the yen’s gains meant that in dollar terms the bonds were up 3.4 per cent.

That story was reversed for UK gilts, which were up 2.9 per cent in local currency terms but were down 0.5 per cent in dollar terms, amid fresh political turmoil as a failure to deliver Brexit means that Prime Minister Theresa May will be heading out the door as soon a successor is chosen.

Emerging market debt managed to weather the storm reasonably well, with local and dollar denominated bonds registering modest gains. Developed market credit did less well; US high yield bonds dropped by more than 1 per cent during May while their  euro zone counterparts lost slightly more.

05

In brief

barometer june 2019

Asset allocation

We remain underweight equities on global trade tensions.

Equity regions and sectors

We trim utilities to neutral, taking profits.

Fixed income and currencies

We cut UK gilts to underweight amid Brexit uncertainty.