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Barometer: Beware of exuberance

May 2019

Pictet Asset Management Strategy Unit

Exuberant global equity markets suggest optimism on economic growth and corporate earnings. Such expectations are likely to be disappointed.

01

Asset allocation: downside risks persist

Equities had a banner month, thanks in part to continued progress in US-China trade talks and tentative signs of stabilisation in industrial production worldwide.

But the market’s stellar gains – global stocks are up more than 10 per cent so far this year  mask the fact that the world economy is not out of the woods yet.

Globally, economic data has been below consensus expectations for 14 months in a row, the longest stretch since the financial crisis.

World trade, on volume terms, is now at its weakest level since 2009 while business confidence in developed economies is falling. At the same time, investors appear too optimistic about prospects for corporate earnings growth.

In this climate, equities may struggle to add to their recent rally. We therefore maintain our underweight stance on stocks. We remain neutral on bonds.

monthly asset allocation grid
May 2019
may asset allocation grid
Source: Pictet Asset Management

Our business cycle indicators persistently show risks to world economic growth. Our leading indicators suggest global GDP growth will slow to 2.4 per cent annualised by early July from 2.9 per cent at end-2018 – with developed economies responsible for most of that slowdown.

Emerging countries continue to enjoy brighter economic prospects; we expect their growth rates to improve to a yearly 4.4 per cent in 2019 from 4.2 per cent from last year.

The developing world’s outperformance owes a lot to China, where recent fiscal and monetary stimulus has helped stabilise the world’s second largest economy. China’s industrial production has rebounded to the strongest level since 2014, while infrastructure spending and car sales have stopped their precipitous decline. Russia’s economy, meanwhile, should benefit from the recent rise in oil prices.

Our liquidity indicators support our cautious stance on riskier asset classes. Financial conditions may have become less restrictive, but they are not loose.

The US Federal Reserve is still expected to withdraw some USD200 billion of liquidity from the market by September as it reduces the size of its balance sheet while China is no longer going full throttle on monetary stimulus.

We think markets have already priced in the prospect of additional monetary support in the coming months – attaching a 50 per cent probability to a US rate cut this year.

Our valuation scores show equities are not especially expensive. Global stocks trade at a price to earnings ratio of 17 and a price to book ratio of 2  both are around the average of the past 35 years.

We are still concerned about the potential for corporate earnings to fall sharply after their 15 per cent rise last year. Our models suggest profits are likely to grow by just 1 per cent this year, compared with a consensus forecast for nearly 7 per cent.

In the fixed income market, European and Japanese government bonds remain expensive.

Disappointing reality

G10 economic data has been below expectations

economic data and equities chart
* MSCI All-Country World index and JP Morgan Global Bond Index. Source: Citi Economic Surprise Index, Datastream, data covering period 31.12.2010 – 19.04.2019

Technical signals are generally supportive for equities and bonds.

They also highlight that implied volatility for equity markets has fallen sharply of late, while the MOVE volatility index for bonds is also back towards record lows.

Given this, it has become cost effective to deploy call options to hedge against the possibility of a sentiment-driven “melt-up” rally in equities – like the one seen in 1999. Such a risk is especially high as portfolio flows data shows institutional investors have yet to fully participate in the recent rally.

02

Equity sectors and regions: margin for disappointment

The S&P 500 hit all-time highs in April with investor optimism fuelled by rising corporate margins. But we remain underweight US stocks, and are instead attracted to the better growth prospects and valuations of emerging markets.

Net profit margins in the US are now two standard deviations above their long-term average at 11.5 per cent. Analysts’ consensus forecasts point to them rising even further, to reach 12.8 per cent by 2021 – widening the gap versus history to three standard deviations (see chart).

profit expectations
Actual profit margins and I/B/E/S forecasts for national MSCI indices
profit margin forecasts chart
Source: Datastream, I/B/E/S. Data covering period 01.02.2004-01.04.2019; dashes show forecasts for 2019-2021.

Such lofty expectations are at odds with the macroeconomic environment. For the first time since the late 1970s, US real wages are increasing more than labour productivity. Interest costs and inflation are both trending higher, while economic growth is slowing. Persistent dollar strength is an additional headwind.

We believe a significant margin squeeze is inevitable. Indeed, the shape of the US Treasury yield curve – which has inverted so that yields on 3-month paper exceed those on 10-year maturities – points to a circa 30 per cent cumulative decline in US profit margins over the next five years, based on historic performance.

Indeed by some measures corporate margins in the US have already started to fall and we think this trend has much further to run. This is worrying for investors as corporate margins typically explain around 90 per cent of the variance in earnings by our calculations. We are thus underweight on US equities, a view which is further supported by valuations – it remains the most expensive region in our valuation model.

In contrast, we are overweight on emerging market equities, where valuations are less stretched – especially in emerging Europe – and where the economic momentum is stronger than in the developed world. Based on our leading indicator, the emerging-developed market growth differential is at the highest level for half a decade.

In China, Beijing’s successful stimulus measures bode well for the Chinese stock market over the medium horizon although in the near term much of the good news may be already priced in. Their success in growing private sector liquidity is encouraging. 

We also like the UK, which offers an attractive dividend yield of 4.8 per cent alongside a cheap currency.

Within our sector allocation, we maintain a fairly defensive stance, with overweight positions in consumer staples, utilities and healthcare. The allocation to healthcare has gone against us on news that there is significant bi-partisan support for reform of the industry. However, we think that the selloff was a significant over-reaction. The sector remains a defensive and has the most negative correlation with our global leading indicator.

On the flip side, we are underweight on the two most expensive sectors – consumer discretionary and IT. 

03

Fixed income and currencies: running out of upside

Global bonds have become so expensive that it leaves us questioning how much upside there remains for most of the fixed income market, from the riskiest corporate borrowers to the safest sovereign debt. As a result, we remain neutral on bonds overall and retain our underweight stance on most credit and developed sovereign debt markets.

Fixed income has benefited enormously from US Federal Reserve’s volte face on policy. Now that the central bank has stopped hiking rates, investors are focused on what might prompt it to cut instead – indeed, the market seems convinced that it now has a dovish bias. About a quarter of the global bond market now offers a negative yield, up around two-thirds since last October.

But investors appear to be ignoring the fact that while the Fed has some scope to ease, other central banks are bumping up against the lower bound for official rates. What’s more, on a global basis central banks are still shrinking their balance sheets – only China has been providing additional monetary stimulus. At the same time, while core inflation is low across much of the developed world, it’s still above bond yields. As a result, real yields on global bonds remain deeply negative (see chart).

losing money

Global bond (JPM GBI) yield, %, vs global core inflation, % change on year

bonds vs inflation chart
Source: Bloomberg. Data as of 23.04.2019. 

Headline inflation rates will be boosted by rising oil prices – they’ve gained more than a third in the year so far.

The recent rally has left investment grade bonds, and high yield credit on both sides of the Atlantic look worryingly overpriced. Although it’s impossible to judge how long valuations will remain at these levels, being caught holding a large position in an illiquid asset class when sentiment turns is hazardous. Hence our underweights across both investment- and non-investment grade bonds in both Europe and the US. 

On the other hand, we are maintaining an overweight on emerging market local currency and dollar-denominated bonds on the back of the deep undervaluation of emerging market currencies. In aggregate, our model shows they are trading by as much as 25 per cent below fair value against the dollar. Their better growth prospects thanks to China’s rebound offers further support.

China’s successful use of a combination of fiscal and monetary policy to mitigate the negative impact of trade tensions with the US has given the economy enough of a lift for its policymakers to start removing some of the monetary stimulus. A tick up in industrial production could be an early signal for a rebound in the renminbi. While the dollar is significantly overvalued, we largely retain a neutral stance on the currency in the absence of compelling alternatives. Still, we remain overweight gold on expectations that the dollar has peaked. 

04

Global markets overview: stocks surge

Global equities rallied in April, with the MSCI World Index scaling record highs (see chart). The gains were driven by cyclical, high beta sectors. Financials, IT, communication services and consumer discretionary sectors gained between 5 and 7 per cent each over the month, in local currency terms.

Powerful rally

Change in MSCI World Index in local currency terms

Change in MSCI World Index in local currency terms
Rebased to 01.01.2014. Source: Datastream. Data covering period 01.01.2014 - 24.04.2019

In contrast, healthcare and real estate underperformed, finishing April in the red.

The energy sector eked out a gain of just 0.4 per cent despite a 7.5 per cent rally in the price of oil. One reason for the breakdown of the traditionally high correlation between energy stocks and oil itself could be the fact that the oil price gains are in part due to geopolitical tensions, rather than to growing demand for crude. The forward curve for crude oil point to a fall in prices in the future; until this changes a material re-rating in energy stocks is unlikely. 

On a regional basis, most major markets achieved solid gains. European shares added over 5 per cent, while the US market rose 4 per cent. Strong consumer spending data helped the S&P 500 hit record highs.

Global bonds lost a bit of ground. Most major sovereign bond market were flat or negative, with the biggest losses sustained by gilts. UK government debt lost 1.6 per cent after Britain won an extension on its departure from the European Union and parliament voted through a bill to prevent a no-deal Brexit.

Corporate debt fared better, with gains of 0.5 to 1.5 per cent. High yield was particularly strong, both in Europe and US.

The dollar edged slightly higher, setting a two-year high against a trade-weighted basket of currencies. 

05

In brief

barometer may 2019

Asset allocation

Equities should struggle to extend their recent rally. We remain underweight on stocks, while we keep our neutral stance on bonds. 

Equity regions and sectors

We are underweight US stocks, while preferring emerging markets and UK.

Fixed income and currencies

We retain our underweight stance on most credit markets.