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Barometer: A correction looms for equities

April 2019

Pictet Asset Management Strategy Unit

With developed economies under pressure and corporate profit growth slowing, prospects for most stock markets look uninspiring. 

01

Asset allocation: equities are a turn off

A powerful rally across global stock markets since the start of the year has lifted equity valuations to levels that are at odds with our downbeat expectations for corporate profit growth. This has prompted us to cut equities to underweight and upgrade cash to overweight.

Stocks have almost fully recovered the losses sustained during last year’s fourth quarter panic thanks to  policy U-turns in both the US and China.

The US Federal Reserve put the brakes on its aggressive liquidity squeeze, by halting its rate hike cycle and flagging a potential end to its balance sheet reduction. Slowing economic growth forced the Chinese to turn their attention from campaigning against the country’s shadow banking sector, to re-starting credit growth and injecting fresh fiscal stimulus. And meanwhile, the trade war between the two countries was nudged off the front burner.

While it’s true that a softening of attitudes could pave the way for a healthier economic environment later this year, we remain cautious. Corporate profit margins are under increasing pressure from higher wages in an environment where firms are reluctant to raise prices. And with profits looking more vulnerable than analysts are willing to acknowledge, there’s scope for some negative surprises in the coming quarters.

monthly asset allocation grid

April 2019

Asset allocation April grid
Source: Pictet Asset Management

Our business cycle indicators highlight a deterioration in developed economies’ prospects. Gloomy sentiment surveys could well be overstating the case, but it’s clear growth is slowing. 
Our leading indicators suggest that developed economies will grow by just 1.8 per cent this year from 2.2 per cent in 2018. Emerging market economies are doing considerably better. Growth should come in at 4.6 per cent for the full year – and would be stronger if the two big problem countries, Turkey and Argentina, were stripped out.

For all this, the slump in global trade appears to have bottomed out and there are some signs of modest recovery. As ever, the Chinese government is determined to support the country’s economy. It plans to inject stimulus equivalent to 3.8 per cent of GDP in the form of infrastructure, public spending and trade measures in 2019. That might be relatively modest compared to past measures, but it’s also likely to be increased should the need arise. Something to watch out for is the degree to which the Chinese authorities favour tax cuts over infrastructure spending.

slip sliding away: Earnings slow as growth eases

Global corporate profits vs world leading index

Global corporate profits vs world leading index
Source: Pictet Asset Management, Datastream. Data covering period 01.01.1989-27.03.2019. 

Our liquidity scores suggest a stabilisation in credit conditions after last year’s sharp tightening of the monetary reins. Investors should expect a mildly negative follow-through from previous policy moves, though. For instance, the Fed will be shrinking its balance sheet by another USD200 billion before calling a halt to its quantitative tightening programme. But an end to a squeeze is in itself stimulatory – there’s evidence that changes matter more than trend. Meanwhile, China, which now represents more than half of the liquidity flowing through the global financial system, is loosening policy again. And the European Central Bank appears to be on the cusp of launching another infusion of long-term bank credit.

Our valuation analysis suggest that global equities are broadly fairly priced – conditional on earnings growth evolving as the market expects. True, analysts are more cautious than they were, with Japanese companies in particular subject to sharp earnings downgrades. Even so, we’re less optimistic than the market generally about the prospects for corporate profits. At the same time, markets seem to be under-pricing the risk of a recession. That’s particularly true for cyclical equity sectors and assets like US high yield credit. Indeed, bonds overall are looking expensive.

Technicals paint a broadly positive picture for fixed income, though they’re supportive of most asset classes. The exceptions are some emerging market currencies.

02

Equity sectors and regions: emerging markets better value than US, euro zone

Equities have recouped almost all the losses they suffered during the late 2018 sell-off, with the MSCI All-Country World Index rising more than 10 per cent since January. But a repeat of this stellar performance looks unlikely in the coming months as deteriorating economic growth – particularly in the developed world - threatens to weigh on corporate earnings.

Worldwide, company profits are expected to rise by just 6 per cent this year, down from a robust 15 per cent in 2018, according to consensus analyst forecasts.  

Our models suggest the picture could be worse than that. We expect earnings to grow by only 1 - 2 per cent this year.

The US stock market looks the most vulnerable to a correction; not only is it the most expensive in our scorecard, but profit margins among US companies look set to contract from record highs of 11 per cent. Already, almost two thirds of US companies reported higher wage costs, according to the National Association for Business Economics Survey.

Emerging market stocks remain our preferred equity investment, due to the developing world’s more resilient economic growth, low inflation and the prospect of a weaker US dollar. China is a particularly bright spot as its sizeable fiscal and monetary stimulus has helped the country transform from a major threat to a stabilising force in the global economy.

Cyclical stocks looking expensive
Market capitalisation of global cyclical stocks relative to defensives, rebased to 0.01.2007 = 100
Cyclicals vs defensives chart
Base currency in USD. Source: Datastream, data covering period 01.01.2007-01.04.2019.

UK equities are also cheap, given the market is well stocked with defensive companies that are trading at what we consider to be unjustifiably cheap levels, unfairly tainted by concerns over Brexit. We are less convinced about euro zone and Japanese stocks mainly as economic growth in these markets remain sluggish – we therefore keep a neutral stance there.

In terms of sectors, we prefer to hold companies in defensive industries such as health care and utilities, which tend to outperform in periods of slowing economic growth.

We keep our underweight stance on economically-sensitive cyclical stocks, such as consumer discretionary and technology – the two most expensive industries on our scorecard.

These stocks are hardly a bargain on a relative basis either: after a brief correction in late 2018, cyclical stocks are once again outpacing their defensive counterparts, by some 4 percentage points so far this year (see chart) – gains which we expect to be unwound if the economy continues to slow. 

03

Fixed income and currencies: credit markets underestimate recession risk

For corporate bond markets, the u-turn in central bank policy – from tightening to the sudden consideration of interest rate cuts – has trumped risks of weaker growth. As a result, the yield spreads of riskier debt over relatively safe fixed income instruments have compressed. For example, the yield premium offered by US high yield bonds over Treasuries has shrunk by some 150 basis points since January.

Given our view that growth will remain weak in the developed world in particular, we believe that credit markets are far too sanguine; US high yield spreads are currently pricing in just a 2 per cent chance of a US recession over the next 12 months, compared to the 10 per cent probability implied by 10 year Treasuries and the 24 per cent probability indicated by the Fed's model (see chart).  

sanguine credit

US recession probability, %, as implied by US high yield bond and Fed model

US recession probability chart
Shaded area corresponds to a recession taking place. Source: Datastream, New York Federal Reserve, Pictet Asset Management. Data covering period 29.12.2006-27.03.2019.

The inversion of the Treasury yield curve – the spread between 3-month and 10-year paper has turned negative for the first time since 2006 – more accurately reflects economic risks and potentially offers some interesting investment opportunities.

In a period of lacklustre economic growth spreads on corporate bonds look too low in absolute terms, as well as relative to their own 20-year history. This is true across the developed credit market in general and for European corporate debt in particular.

Another red flag is that credit quality has deteriorated, with firms having much more leverage on their balance sheets. Covenants designed to protect investors have also weakened as demand for leveraged loans has surged.

Additionally, short-term sentiment and technicals signals are now flashing red, and add to our reasons for maintaining an underweight stance on US and European credit, both high yield and investment grade.

A more a favourable trade-off between risk and prospective return can be found in the emerging fixed income market. We remain overweight emerging market local currency debt, which continues to offer the best value in the fixed income market, according to our models. Despite wobbles in Argentina and Turkey, emerging economies in aggregate look to be on a more solid footing versus their developed peers; positive signs include a strong recovery in consumer confidence across the developing world. Investors in local currency emerging market bonds should also benefit if emerging currencies close some of the valuation gap versus the dollar – according to our models they are still 25 per cent below fair value.

When it comes to currencies, our fair value models show that the greenback is expensive versus most developed and emerging market currencies; against the euro, option implied pricing suggests an appreciation of 3.3 per cent over the next 12 months. However, given the lack of a clear catalyst for a marked depreciation of the greenback over the near term, we maintain a neutral stance on the dollar.

04

Global markets overview: a big quarter

Global stock markets ended the quarter up more than 12 per cent – their best quarterly performance since 2013 – as major central banks put plans to tighten monetary policy on ice and as the US and China inched towards resolving their trade dispute. 

China's equity market ended March sporting their strongest quarterly gains in more than four years. Following a rise of some 5 per cent on the month, the CSI 300 index is up almost 30 per cent on the quarter – making it the world’s best performing market so far in 2019.  

lending to governments a costly business
German 10-year government bond yield, %
German government bond yields chart
Source: Datastream. Data covering period 21.03.2017-26.03.2019.

A surge in M&A activity further fuelled the market rally. Deals worth USD927 billion have been agreed this quarter, up 22 per cent from last quarter and the second strongest start to any year since 2000.

A big jump in oil prices – up by more than a quarter since the start of the year – gave a substantial boost to energy stocks, though IT, real estate and industrials were the stand out sectors.

As equities rallied, so too did global bonds, gaining 1.8 per cent on the month in local currency terms. Indeed, investors are paying to lend to an increasing number of governments over ever longer maturities. The volume of debt trading at negative yields rose past the USD10 trillion mark as central banks abandoned attempts to tighten monetary policy.

For instance, yields on 10-year German Bunds turned negative during the month (see chart). At the same time, yields on 10-year US Treasuries fell below those on 3-month bills for the first time since 2006. Historically, that inversion has tended to foreshadow a recession – though paradoxically, it has also been associated with late cycle equity rallies that can last as long as a year. We remain wary, however, about the likelihood of this happening now: earnings growth is disappointing; valuations are not compelling; and much of the central bank dovishness is priced in.

The concurrent rally in both bonds and equities was particularly friendly for credit markets. European and US high yield debt returned more than 5 per cent and 7 per cent respectively over the quarter, while investment grade markets gained 5 per cent plus.

One of the few losers during March was gold, down 1.5 per cent on the month for a modest 1 per cent gain since the start of the year.

05

In brief

barometer april 2019

Asset allocation

We cut equities to negative and raise cash to overweight.

Equity regions and sectors

Among major regions, US equities look most vulnerable to a correction.

Fixed income and currencies

We like emerging market debt, while remaining cautious on US and European credit.