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Multi Asset

Easing up on the gas 

Barometer
February 2018

Pictet Asset Management Strategy Unit

The stock market has come a long way in a relatively short period. This, and rising bond yields, means the rally could soon run out of steam. 

01

Asset allocation: a note of caution

Global stocks kicked off the new year on a strong note, rising more than 5 per cent in January alone, with many bourses reaching record highs. The magnitude of the rally, and a simultaneous spike in yields on US Treasuries and German Bunds, means we now see limited upside for equity markets over the coming months. Hence we downgrade equities to neutral, raise cash to overweight, and keep our underweight stance in bonds, as we expect strong domestic demand and buoyant labour markets, especially in developed economies, to push inflation higher over 2018. What is more, a surprisingly strong rebound in inflation risks a more hawkish-than-expected response from central banks.

monthly asset allocation grid
February 2018
Barometer grid February 2018
Source: Pictet Asset Management

Our business cycle indicators show the global economy is on track to grow 3.4 per cent this year, having expanded above 3 per cent in 2017. We have become more optimistic about the prospects for the US. Domestic demand has grown at annualised rate of 4.4 per cent in the most recent quarter, the highest in three years; consumer and business confidence close to record levels; a weak dollar is supporting exports and Washington's tax reform should boost economic growth in the next two years. However, this, in turn, is translating into higher price pressures. US core PCE, the US Federal Reserve’s favourite inflation gauge, has risen to 1.5 per cent; we expect it to breach the Fed’s target of 2 per cent in late 2018.

Economic conditions in the euro zone remain buoyant, although growth may be plateauing.

We are more cautious about China’s economic prospects, however. Economic activity has deteriorated as fixed asset investment has fallen sharply in both the public and private sector. Should debt reduction gather pace, growth could decline sharply.  

The rest of the emerging world is faring better; the growth differential between developing and developed economies should widen further after bottoming at 1.7 percentage points in 2016.

Our liquidity readings support a neutral stance on equities. The amount of liquidity provided by the world’s five major central banks is running at 12.5 per cent of GDP, towards the bottom of its two-year range.Another red flag is US monetary policy. With inflation on the rise, we expect the Fed to raise interest rates three times this year.

Tighter US monetary conditions are, however, being partially offset by central bank stimulus in China, as well as a weaker dollar, which supports emerging economies.

Our valuation gauges suggests stocks have limited room to rise further. With money supply rising at a slower rate than the growth in industrial production2 – a differential that serves as our gauge of excess liquidity – earnings multiples could contract by 5-10 per cent over the course of the year. Also, the scope for company earnings growth to beat consensus expectations is limited given the strong upward revisions to profit forecasts in recent weeks. In the US, we believe that a boost from tax cuts is nearly fully discounted by stock markets, not least because analysts raised their estimates for profit growth this year to 17 per cent from 11 per cent shortly after the tax programme was passed. 

investor exuberance 
Investors are more bullish than ever, just as macroeconomic growth appears to be peaking
asset allocation
Source: Thomson Reuters Datastream;  data covering period 29.01.2008-30.01.2018; Citigroup Economic Surprise Index is a ratio showing proportion of data releases beating/undershooting consensus expectations.  

Our sentiment readings have turned negative for equities as they are beginning to signal investor exuberance. The US “bull bear ratio” – which compares the number of bullish and bearish investors – indicates that bulls are firmly in control. Reinforcing the view that investors may be too complacent, IPO activity has been strong and the stock market has seen record four-week inflows of USD77 billion in January into global equity mutual funds and ETFs.3

02

Regions and sectors: Europe not just cheap but cheerful too

Just one month into 2018, global equities have already notched up more than half of the gains we are forecasting for the year as a whole. After such a strong rally, the question is which areas of the market have the best potential for the remainder of the year?

Among the major global equity markets, we believe the answer could be Europe. European stocks are trading at their biggest discount relative to the US in 30 years (see chart). 

value in europe

MSCI EMU index level relative to MSCI US, in local currency

regions and sectors Europe vs US PE
Source: Thomson Reuters Datastream, Pictet Asset Management; data covering period 26.01.1998-30.01.2018 

Of course, just because something is cheap, that's not a reason to buy it. But combine European stocks' attractive valuations with the region's improving economic prospects - we expect euro zone to grow 2.2 percent this year - its negative real rates and a recovery in bank lending, and the investment case is compelling. 

We also remain overweight Japan, where economic conditions are improving. Japanese exports to China and Asia have hit record highs while its manufacturing sector grew at its fastest pace in four years in January. The country's jobs-to-applications ratio, meanwhile, is the healthiest it’s been in four decades, according to official data.

The US also seems to be in reasonable economic shape. But with corporate earnings growth for this year now expected to hit an unusually high 16 per cent, there is a risk that company profits might undershoot forecasts. This is one reason why we remain underweight US stocks. Other red flags include the prospect of higher US interest rates, and the stock market's valuations, which are above average on several measures. The S and P 500 price-to-book ratio, at 3.4 times, is 1.3 standard deviations above its long-term trend for example.

History shows the when markets hit such valuation levels, they tend to suffer a decline of some 5 per cent, annualised.

Elsewhere, with the Fed widely expected to raise rates three times this year, it makes sense to allocate capital to stock sectors that tend to do well in periods when monetary policy tightens. 

This is one reason why we favour financial companies, for which interest rate rises typically result in higher profit margins. The sector also looks better value now than it did three months ago.

On the flip side, utilities are likely to be hurt by rising rates, as such companies have limited capacity to pass on either higher input prices or increased debt servicing costs on to consumers. We have consequently downgraded utilities to negative.

We remain overweight in relatively cheap commodity-related sectors, such as energy and materials. On our models show commodity prices could rise further if industrial production picks up and the US dollar continues to depreciate.

03

Fixed income and currencies: high yield, high anxiety

We have turned more cautious on credit. It is the most expensive asset class on our scorecard, vulnerable to tighter monetary conditions and, historically, the first to come under pressure as financial markets move to the latter stages of the cycle.

We are underweight European corporate bonds and are now reducing our weighting on US high yield debt to negative from neutral in response to a rise in US Treasury yields - 10 year yields recently breached the 2.70 per cent mark, their highest level since 2014. US high yield bonds may not be as expensive as their European counterparts, but their spreads don’t leave investors with much of a buffer against further bad news for the bond market. At 345 basis points, spreads on US high yield bonds are now at the lowest they’ve been since the summer of 2006. And the risk is that the Treasury sell-off hasn’t run its course. 

A healthy US economy – growth is solid, consumers are in buoyant mood, unemployment is low – all point to an increasingly hawkish Fed. Throw in President Trump’s corporate tax cuts, which are expected to act as a significant fiscal stimulus judging by the stock market’s reaction, and the case for three Fed hikes this year becomes increasingly solid with more to come next year. Then there’s the small matter of Treasury bond supply – with the Fed no longer buying bonds and the US government required to fund Trump's tax cuts, the private sector and foreign reserve managers will need to absorb USD1.5 trillion of Treasuries this year and USD2 trillion next - an increase from USD500 billion in 2017.

We are also concerned by a recent surge in outflows from US high-yield bonds – of nearly 1 per cent of net assets held in US high yield bond funds in just the last two weeks, according to data from EPFR.

wafer thin

US high yield spreads over Treasury bonds, basis points

fixed income US HY spreads
Source: Bloomberg;  data covering period 30.01.1998-30.01.2018 

Buoyant domestic economic conditions would normally translate into a stronger dollar, except they haven’t. Although we think it will decline over the long term due to, among other things, falling US productivity, the greenback’s recent weakness is still something of a conundrum. In the last three months, not only has US economic data proved better than markets had expected, but interest rate differentials between the US and the euro zone have widened – which would normally boost the dollar. Yet the currency is down some 4 per cent versus the euro since the beginning of 2018. 

It’s possible that technical factors are at the root of dollar weakness, such as corporate currency hedging and, potentially, central banks boosting  their reserves holdings of the single currency as the region’s economic growth picks up and its existential crisis becomes a thing of the past. But with fundamentals failing to explain foreign exchange movements, we’ve decided to take a neutral position on currencies.

At the same time, the market is starting to re-evaluate its view of sterling. Brexit will continue to dog the UK economy for years to come, but the fact that it hasn’t (yet) led to an economic catastrophe has prompted some short covering of the pound.

Our response to these countervailing forces is to lift our euro and sterling position to neutral from underweight.

04

Global markets overview: surging stocks

Equities delivered their traditional new year rally and – despite a slight pullback in the final days of January – claimed the mantle of the best performing asset class for the month.

Emerging market stocks led the charge, with particularly strong showings from Latin America and EM Asia (up 8.3 per cent and 7.3 per cent, respectively, in local currency terms). Such strength partially reflects buoyant demand, with foreign investors allocating USD13.5 billion into emerging equities in January – the highest inflows in 18 months, according to data from the International Institute of Finance (IIF).

In the US, the S and P 500 return ended in positive territory for an unprecedented 15 months in a row.

UK stocks were the clear laggards. They finished 2 per cent in the red, weighed down by an appreciating sterling - which crimps earnings generated by UK multi-national companies, as well as the high-profile collapse of building and services company Carillion and a profit warning from rival Capita.

Among sectors, technology stocks fared especially well, with a rally of 7.1 per cent, while utilities struggled in the rear with a 1.9 per cent fall. Healthcare was the notable exception to the broad outperformance of cyclical versus defensive stocks. Alongside technology, healthcare is seen as one of the biggest beneficiaries of US tax changes, which will allow companies to repatriate – and use – billions of dollars of cash held overseas.

EQUITIES , BOND YIELDS IN TANDEM

MSCI ACWI global equities index compared to US 10 year Treasury yields

markets bonds vs equities
Source: Thomson Reuters Datasteam, Pictet Asset Management;  data covering period 30.09.2016-30.01.2018 
 

In a warning sign for investors, the VIX index of implied stock volatility rose from a record low of 9.15 set in the first week of January to 14, an unusual move at a time of rising equity markets.

Most major types of fixed income assets finished the month either in the red or little changed in local currency terms. US government bonds posted a loss of 1.4 per cent, with benchmark 10-year Treasury yields approaching four-year highs after the Fed said it sees inflation picking up this year. The comments reaffirmed market expectations for another interest rate hike in March. US investment grade bonds also weakened.

In the foreign exchange market, the main feature was dollar weakness. The greenback weakened across the board, with the biggest moves seen versus the Mexican peso, sterling, Swiss franc and Brazilian real.

05

In Brief

february 2018

Asset allocation

We downgrade equities to neutral, raise cash but remain underweight bonds

Regions and sectors

Maintain preference on Europe and Japan, while cutting utilities to underweight

Fixed income and currencies

We cut US high yield to underweight in response to tightening spreads