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Asset allocation

Smooth sailing for stocks

Smooth sailing for stocks

December 2017

Pictet Asset Management Strategy Unit

Investors shouldn't stand in the way of a booming economy and ample monetary stimulus.


Asset allocation: thumbs-up for stocks

Investors shouldn’t stand in the way of a booming economy. That’s the conclusion we would draw from our analysis of financial and economic conditions. With global output having expanded at a healthy clip for more than a year, and the euro zone transformed from weak link to economic dynamo, there is little to suggest that riskier asset classes will hit an air pocket in the near term. The picture looks just as bright when the focus shifts to business prospects – globally, corporate earnings are rising strongly at some 16 per cent year-on-year.

What is more, even if monetary stimulus is steadily being withdrawn, central banks are in no rush to abruptly turn off the taps and shock global markets.

For these reasons, we are retaining our overweight stance on equities.


December 2017

Source: Pictet Asset Management

Nevertheless, we have become a little more concerned about inflation. With labour market conditions tightening in both the US and Europe, we expect wage increases to gather strength during the first half of 2018, which could ultimately feed through into inflation and compress stocks’ price-earnings multiples.

The inflation threat partly explains why we retain our underweight position in fixed income; the other main factor underpinning our stance on bonds is that yields on corporate debt in particular look low relative to the rate of economic growth.

Our business cycle indicators bear testimony to a robust economic expansion worldwide. What we find particularly encouraging is that the improvement in economic conditions is partly down to an in increase in business spending. By our reckoning, capital investment should increase by 5 per cent in 2018, globally, up from this year’s 3.3 per cent rise. We expect US growth to accelerate to 2.4 per cent in 2018, while emerging economies should expand by 5 per cent. The euro zone and Japan will keep above-potential growth rates.

Our liquidity indicators are reasonably supportive for equities. The volume of monetary injections provided by the world’s five major central banks remains at a high 12 per cent of nominal GDP.It is in the euro zone and Japan where credit conditions are most supportive for stocks. Lending to non-financial corporations across the region increased 2.9 per cent in the 12 months to October, according to European Central Bank data, the strongest since June 2009. Our indicators show US private-sector credit expansion remains weak in real terms. China, meanwhile, continues to tighten the monetary reins.

growth strengthening
asset allocation.png
Source: Pictet Asset Management, CEIC, Thomson Reuters Datastream. *weighted average of 39 countries leading indicators; data covering period  31.12.2010-30.11.2017

Valuations are reasonable for stocks but lofty for many fixed income asset classes. Among equity sectors, the technology sector appears expensive, trading at a price to book ratio of 5. However, with a free cash-flow yield of some 4.8 per cent, US technology companies compare favourably to the S and P 500 Index, which offers a yield of 4.3 per cent, and are therefore very profitable. European high yield debt is among the most expensive asset classes in our scorecard, with such bonds yielding 3 per cent, a historic low.

Our technical gauges suggest being overweight equities and underweight bonds. That said, one warning sign comes from the institutional investor surveys we monitor, which show that allocation to equities is approaching a historic high, potentially limiting the scope for further stock market gains.


Regions and sectors: trimming fat in cyclicals

This has been a very good year for equities in general and for cyclical stocks in particular. Since hitting a trough in February 2016, cyclicals have outperformed their defensive counterparts by 35 per cent on an aggregate market capitalisation basis and, measured on their price to earnings ratios, are trading at a 20 per cent premium, which is close to previous cyclical peaks.2

While this outperformance has much to justify it, having come against a backdrop of improving global growth, valuations for certain segments of the equity market have risen far beyond levels which are justified by economic conditions. Broadly speaking, cyclical stocks' valuations are now consistent with a US ISM manufacturing index level of 65 – compared to a current level of 58.2 – and annual GDP growth of over 4 per cent. With economic confidence at a record high, inflation rising, and monetary stimulus easing, we think it is time to reduce exposure to some of the most expensive cyclical sectors.

To this end we downgrade technology to neutral and industrials – the most expensive sector on our valuation scorecard – to underweight. We see scope for greater gains in materials, especially mining stocks, which are trading at attractive levels. 

Our other underweight positons are consumer staples and consumer discretionary – both sectors are expensive and vulnerable to the expected rise in inflation.

Conversely, we remain positive on energy as the oil price rebounds and on financials, which offer good valuation and improving balance sheets.

Cyclicals getting rich
Source: Pictet Asset Management, Thomson Reuters Datastream; data covering period 31.10.1997-30.11.2017

From a regional perspective, the euro zone continues to offer better value than the US. Economic growth in Europe is running well above its long-term average, inflation is still relatively low and earnings are rising by 10 per cent a year. The stock market does not yet fully reflect this, which suggests scope for further gains, both in absolute terms and relative to US equities. Historically, the euro zone tends to outperform the US in the later stage of a bull market.

We also like Japan, where corporate earnings growth is close to a record high and monetary conditions are supportive. Although Japan has a high share of cyclical stocks, they are relatively inexpensive compared with global peers, trading on modest price to book ratios, which are below 2. It is also worth noting that Japan is the only region whose stock market return year-to-date remains below the rate at which corporate profits are expected to rise next year.

We remain neutral emerging markets and are reluctant to raise our exposure as valuations are becoming harder to justify, with Latin America in particular looking expensive. There are also several risks on the horizon, including the possibility of protectionism taking hold in the US, uncertainty surrounding the composition of the US Federal Reserve's monetary policymaking board and geopolitical tensions over North Korea.


Fixed income and currencies: cautious on credit

With many bond markets trading at high valuations at a time when central banks are gradually tilting towards normalising monetary policy, we have become a little uneasy. We are particularly cautious when it comes to developed market corporate bonds. 

One part of the market that’s particularly vulnerable to a correction is European high yield debt which, for the first time ever, is yielding less than the 3.3 per cent offered by European equities (see chart). To us, that is a clear signal that valuations are lofty. Another red flag comes from our technical indicators, which show that investor positioning in the asset class is excessively bullish.

What is more, although markets have responded positively to ECB's commitment to keep buying corporate credit, the euro zone's booming economy and unexpectedly strong inflationary pressures in Germany suggest the central bank may soon have reason to ease back further on stimulus, which could weigh on corporate debt.

a red flag for high yield bonds: stocks offer better yield than debt in europe
Source: Pictet Asset Management, Thomson Reuters Datastream; data covering 31.10.2007-30.11.2017

Even though US corporate bonds look better value than their European counterparts – trading at double the yield – we are reluctant to raise our exposure there either. It’s worth bearing in mind that there have already been jitters in US high yield, which has seen a flurry of investment outflows in recent weeks.

Separately, we have decided to raise our exposure to the Japanese yen. Our technical readings suggest investors are overly bearish on the currency.

At the same time, Bank of Japan has been offering some hawkish guidance, including the suggestion that its yield targeting measures could be moderated over the coming months.3

We however maintain our underweight stance on the euro.


Global markets overview: another great month for stocks

Lucky 13
Source: Pictet Asset Management, Thomson Reuters Datatream; data covering period 31.08.2016-31.10.2017

Equities outperformed bonds in November as strong economic data and progress on US tax reform boosted investor sentiment. The US was the best performing developed equity markets in local currency terms, with the MSCI US index gaining some 3 per cent. The S and P 500 index saw the 13th successive month of positive total returns for the first time in over 90 years. 


European equities fared less well, ending in negative territory on the month as a stronger euro weighed on stocks of export-dependent companies. The rally in technology stocks appeared to be fading. They ended the month virtually flat having gained almost 40 per cent since January. Oil rose 3 per cent, with Brent hitting the highest level in two years after OPEC and Russia agreed to extend production cuts.

Within fixed income, yields on two-year US bonds hit a nine-year peak at one point as strong third-quarter GDP data cemented expectations the Fed would deliver more interest rate hikes over the next several months. 

Rising Treasury yields weighed on high yield bonds, with both US and European markets falling by 0.3 per cent in local currency terms. Bank of America Merrill Lynch data showed investors pulled USD6.8 billion from high yield bond funds in one week, their third largest weekly outflows on record.

The dollar fell 1.4 per cent against a basket of major currencies, while the euro outperformed the yen by rising 2.4 per cent versus the US currency.

Sterling hit a two-month high against the dollar as the UK and the European Union moved closer to a Brexit deal. The Turkish lira was the worst performer, falling nearly 3 per cent on the month to hit a record low against the dollar amid signs of a further deterioriation in relations between Ankara and Washington. 


In brief

December 2017

Asset allocation

We retain our overweight stance on equities.

Regions and sectors

We downgrade tech to neutral and industrial to underweight. We see more upside potential in materials.

Fixed income and currencies

We're cautious in most areas of credit. We upgrade the Japanese yen to neutral.