From a global deterioration of valuations to stabilisation

MAIN CONVICTIONS

GLOBAL CROSS-ASSET STRATEGY

“America First”, the Italian crisis and the slowdown in euro zone growth are some of the factors that have contributed to the global deterioration of valuations. Year-to-date market returns are no longer representative of fundamental factors, including earnings growth, dividend yield and price-earnings ratio, i.e. how much investors are willing to pay per dollar of earnings. Where do we stand now? And what could be the catalysts of a change of market trajectory?

US equities have outperformed all other regional equity asset classes so far this year. In their corner, they had the very supportive Q1 tax cut, strong earnings growth and a strengthening USD. The tax cut is unlikely to be repeated and  earnings growth, although being revised downward by consensus, is still positive. 

Today, market pricing is much more prudent vs. central bank expectations. While the Fed is still communicating on 3 hikes next year, the market is pricing less than 1 and we expect 2.

Donald Trump has been an unpredictable president. Going forward, our research shows the pursuit of earnings growth – albeit slower – and that negative returns are not the most likely scenario. Holding US equities therefore remains one of the pieces of our asset allocation strategy jigsaw puzzle.   

Outside the US, the slowdown in economic momentum has pulled equity markets down.

In terms of performance, Emerging countries, especially China, have been the most penalised since the beginning of the year, with Emerging market equities underperforming (in local and hard currency). Lately, however, the trend has started to reverse. Performance figures might not be positive but Emerging markets are no longer last. Looking ahead, headwinds would lose in strength if the Fed was more dovish than expected and if the USD stopped appreciating. Besides those two factors, investors also have to take into account how active the Chinese authorities are at mitigating the impact of a slowing global growth and boosting its domestic activity with monetary policy, fiscal policy and a devalued currency. Those measures aim at supporting corporate and private entities’ exports, consumption and investments. We do not expect those measures to have an immediate impact. We even expect that, because of the trade war, Chinese goods importers have ordered more than needed ahead of the initial tariff-application deadline, thereby creating a future short-term gap. Nevertheless, adding Emerging market equities as we go along is our way of completing the strategy jigsaw.

In the euro zone, we have reduced visibility, high vulnerability and the degree of sensitivity to policy crisis. Ever since the Euro sovereign debt crisis of 2010-2011, the euro zone has been hitting a glass ceiling, unable to unleash its potential, and stuck behind the US and behind – or on the same level as – Emerging markets. Current drivers of political uncertainty include the Brexit deal – or lack thereof -, political and social unrest in change-resisting France, Italy’s inability to meet EU fiscal rules and the upcoming springtime European Parliament elections (23-26 May 2019). 

The euro zone also has a sectorial allocation that is less supportive than in the US. For instance, the euro zone index has fewer “Tech” names than its US counterpart (6% vs 24%). Some of the EU sectors are also “on standby”, i.e. waiting for deep structural changes or rate hikes from the Central Bank. Also, the slowing growth has affected the region sooner, collateral damage from the trade war and political division. However, we should not underestimate the upside potential of the region, where valuations are below historical levels, earnings growth is positive and above-potential growth is expected. 

In this context, we still prefer equities to bonds as we expect the global expansion to continue, albeit at a slower pace, and our 12-month expected returns are more attractive for equities than for bonds. The business cycle keeps moving forward. In the meantime, we are maintaining some cautiousness on credit and a negative tilt on bonds, with the exception of inflation-linked bonds and emerging market debt. The main risk to our scenario remains the geopolitical tensions.