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April 2018

Clouds but no storms

Plateauing economic growth higher rates and escalating geopolitical tensions are making it harder to find attractive assets. But not impossible.


Asset allocation: steady course through troubled waters

Clouds are gathering over the global investment landscape: Washington and Beijing are rattling sabres on trade, the US Federal Reserve has become more hawkish and world economic growth has turned lower at a time when earnings forecasts are running stubbornly high.

Some turbulence is to be expected across financial markets, but we do not think it will turn into a full blown storm. This is a time for a steady hand on asset allocation rather than for rash movements in or out of major asset classes.

monthly asset allocation grid

April 2018

asset allocation grid

Source: Pictet Asset Management

On balance, our analysis suggests retaining a neutral stance on equities, and an underweight on bonds, which are already feeling the pinch from tighter monetary policy. Given the relatively jittery investor sentiment and the potential for more short and sharp market jolts, we also favour an overweight in cash – both to reduce risk exposure and to be ready to invest in any opportunities that may arise.

Firstly, we believe an all-out trade war is in no one’s interest, and therefore some kind of compromise will probably be reached. The more conciliatory moves from the US administration in recent days – including the recent trade agreement with South Korea – support this view.

The economic outlook is also not as worrying as it may at first seem. While the momentum of world growth shows signs of topping out, at 3.6 per cent annualised it is still running well above potential. Our business cycle indicators show the US looking particularly strong, with its leading indicator hitting a six-year high. We therefore see scope for the world’s largest economy to beat consensus forecasts in the second quarter of the year, as President Donald Trump’s tax cuts boost business investment. On a global level, that should help to offset the weaker activity in China’s industrial sector.

draining away
Liquidity flow for US, China, euro zone, Japan and UK, % of nominal GDP
global liquidity flows

Source: Datastream. Policy liquidity flow calculated as central bank net injection over preceding 6 months, as % of nominal GDP, using current-USD GDP weights. Data covering period: 15.12.2006 – 15.03.2018.

True, the expansion will probably still fall short of the lofty levels factored into earnings forecasts (see “Regions and sectors”). But any disappointment may be easier to swallow after the recent market correction, which has pushed stock prices down to much more sustainable levels.

Liquidity is getting tighter, but in a steady and controlled manner (see chart). According to our indicators, liquidity in the US tightened in January, while conditions in Japan turned to neutral from expansionary in February, and those in the euro zone followed in March. We would expect this trend to continue, leading to a gradual – rather than sudden – increase in bond yields. We are also closely watching the rise in short-term LIBOR rates in the US for signs of further tightness in funding markets.

According to our valuation model, equities have moved from expensive to neutral for the first time since August last year. This is true regardless of whether you compare prices to earnings, book value or dividends.

Technical indicators show particularly negative trends in investment grade and high yield bonds, in contrast to positive signals on emerging market local currency debt. We also take comfort in the fact that the extreme levels of short positioning in VIX futures has completely been reversed, which reduces that vulnerability for the market.


Regions and sectors: source of alpha

At best, equities are, in aggregate, likely to tread water over the next few months. Economic momentum is plateauing while central banks are draining the liquidity that has supported valuations during recent years. Yet with some parts of the world progressing much further along the business cycle than others, we expect the dispersion of returns among both regional equity markets and sectors to be high, presenting numerous tactical investment opportunities.

In terms of regions, the US remains the most expensive equity market, which leaves limited room for it to rise further. What is more, investor expectations for this year’s earnings growth from S and P 500 companies – currently at 19.5 per cent– are consistent with nominal US GDP growth of 6 per cent, which looks unlikely.

We are becoming less optimistic about Japanese equities. While the country’s long-term growth prospects remain sound, the economy has lost some momentum in recent months, particularly when it comes to exports and construction activity. The recent strength in the yen should also weigh on exports. What is more, the Bank of Japan’s decision to reduce the amount of bond buying in January suggests the central bank may follow its peers in removing monetary stimulus. However, Japan is still one of the cheapest major equity markets and structural trends – on corporate governance, for instance – are more positive.

Elsewhere, we see opportunities in the euro zone thanks to expectations for resilient corporate earnings growth.


Energy companies have underperformed global stocks

energy stocks versus oil price

Source: Thomson Reuters Datastream, MSCI. Data covering period 25.03.2016 - 27.03.2018.

Prospects for energy stocks look brighter than before. The oil price should continue to be supported by a weaker dollar as well as by geopolitical tensions on Iran and Venezuela curbing potential supply. This should help boost revenue among energy companies. Since mid-2017, not only have these stocks lagged the broader global equity market, they have also trailed oil prices – which have risen nearly 60 per cent in that time (see chart). We expect this gap to close gradually.

We have slightly increased our exposure to consumer staples stocks, which look better value now following a correction. We also value their defensive characteristics.

Technology stocks have become cheaper. However, their valuations are not yet attractive enough to prompt us to raise our exposure from neutral. Fears about increased regulation and jitters over a trade war between the US and China continue to weigh on the IT industry, which almost single-handedly led last year’s global equity rally. We remain optimistic about the long-term earnings outlook for the tech sector but believe this is already priced in.


Fixed income and currencies: emerging attractions

The stars may not be fully aligned for emerging market local currency bonds, but they’ve moved in the right direction, prompting us to lift our allocation to overweight from neutral.

Broadly stable global economic growth, solid commodity prices, a softening dollar and relatively favourable inflation trends should all continue to lend support to the asset class.

Trends for the global economy aren’t as unequivocally bullish as they were, but we see no reason to believe a downturn is in the offing. Meanwhile, oil prices have led the commodities complex higher since last summer. The still positive economic backdrop should continue to support raw materials for now. And President Trump’s administration appears keen on keeping downward pressure on the dollar – a weak US currency tends to be good for emerging market assets by lifting commodity prices and  boosting investment flows. That’s relevant because a third of the benchmark EM local currency bond index (GBI-EM GD) is represented by commodity-intensive Latin American economies, with another 4 per cent in Russia, a commodities powerhouse.  

Paying out

JPM GBI-EM Bond Index (local currency) yield, %

local currency bond yield

Source: JP Morgan, Datastream. Data covering period 25.03.2016 - 27.03.2018.

Finally, emerging market inflation has drifted lower during recent years, while price pressures have been heading higher among developed economies. This boosts the relative attractiveness of emerging market bonds, which tend to be higher yielding. Over the past two decades, emerging markets inflation has, on average, been 3.9 percentage points above that of developed countries, but the latest reading showed a gap of just 1.2 per cent.

Elsewhere, recent market moves have generally pushed up yields on developed world government debt higher since the start of the year: what was fairly expensive now looks a bit more reasonably valued. But the move hasn’t been enough to justify a shift from our moderate underweight on fixed income. We remain overweight longer-dated US Treasury bonds as a hedge against market turbulence and because they’re one of the more attractive sources of positive fixed income yield – yields here are closer to nominal economic growth than in other regions.

We also lifted our stance on gold to an overweight from neutral to take advantage of its safe haven properties, as well as to help offset any further potential dollar weakness. Although the dollar is close to fair value against its major crosses, it could well continue to drift lower, notwithstanding the Fed’s rate hikes and balance sheet reduction. We’ve kept our overweight on the yen and neutral position on the dollar’s other major crosses.


Global markets overview: equities sink further

A red tide washed through equities during March, leaving most developed markets under water for the year. President Trump’s decision to target Chinese exporters with a series of tariffs in an effort to cut the US’s trade deficit unsettled investors. The mood was then made worse by Facebook’s travails over data privacy and Trump’s attack on Amazon.

Most major markets dropped a bit more than 2 per cent during March – leading equities as an asset class to a monthly deficit of 2.2 per cent in local currency terms. The weakness came despite a record amount of merger and acquisition activity during the first quarter, totalling USD1.2 trillion globally. Overall, emerging markets outperformed slightly, supported by a relatively modest 0.3 per cent decline in Latin American stocks.

Globally, IT lost 3.1 per cent on the month though still managed to hold nearly 3 per cent gains on the year – the only sector to remain positive for the year to date (see chart). Telecoms have been the biggest losers in 2018 so far, down 6.8 per cent, having also been among the market’s worst performers last year.

tech correction

Nasdaq index level

Nasdaq stocks index

Source: Thomson Reuters Datastream. Data covering period: 25.03.2016 – 27.03.2018.

By contrast energy stocks edged up thanks to a near 8 per cent surge in oil prices during March. Utilities also gained ground, up 3.6 per cent on the month, thanks to their bond-like qualities as investors fled riskier assets.

Bonds were up 1.1 per cent on the month, leaving them broadly flat year to date. UK gilts registered the strongest performance as inflationary pressures eased and sterling recovered further ground from its post-Brexit lows. Emerging market local currency bonds edged up during the month to register the best year to date performance among fixed income segments – up 4.4 per cent.

Corporate bonds were little changed in March. Most are down on the year, having caught the equity market’s mood, though declines are much more modest, particularly in the euro zone, where European Central Bank buying continues to offer support.

Currencies were a mixed bag. The dollar lost a bit of ground against the euro, yen and sterling but picked up elsewhere, suggesting it may be starting to see a floor after some hefty declines.    


In Brief

aPRIL 2018

Asset allocation

We remain neutral on equities, underweight on bonds and overweight on cash.

Sectors and regions

We have become more bullish on energy stocks; we also like euro zone stocks.

Fixed income and currencies

We have lifted both emerging market local currency bonds and gold to overweight from neutral.