We retain our overweight stance on stocks because the outlook for global equities is encouraging as central banks continue to provide considerable amounts of monetary stimulus and the world’s economic prospects remain positive on the whole. Even though a number of stock indices have hit record levels in recent weeks, equities are not expensive compared to bonds.
We also remain neutral on bonds as the European Central Bank’s quantitative easing programme and improvements in economic growth should exert opposing forces on government debt, keeping yields in a narrow range. Our stance on the USD is unchanged at neutral.
In our regional equity allocation, we keep our preference for Europe and Japan, where we see stronger earnings momentum and more favourable liquidity conditions than in the US.
When it comes to sectors, we maintain a cyclical tilt in our portfolio, with a preference for sectors that stand to benefit from any increase in capital spending. This is expressed through an overweight in industrials, a sector that also exhibits attractive valuations. Technology is another attractively valued sector that should draw support from increased business investment. We also like banks, which have repaired their balance sheets and are poised to capitalise on the upturn in the credit cycle.
With yields on benchmark government bonds at unsustainably low levels, the continued monetary stimulus provided by central banks worldwide should disproportionately benefit areas of the fixed income market where valuations are either close to or below fair value.
This is why we continue to favour USD denominated emerging market debt and European high-yield bonds. Our models show that valuations for USD emerging market debt are clearly at odds with sovereign borrowers’ credit credentials. With the exception of Ukraine and Venezuela, there is nothing to suggest sovereign borrowers are finding it more difficult to service their external debt even if emerging market growth remains sluggish.
By our reckoning, the market’s aggregate yield spread is one standard deviation higher than what we consider to be fair value. What is more, supply and demand dynamics should also support the asset class. The data we monitor show that USD emerging market debt has attracted some 80 per cent of the investments that have flowed into emerging market fixed income so far in 2015. Also, the volume of sovereign bond issuance in emerging markets has been eclipsed by the amount of cash investors have received from bond redemptions and coupon payments.
We remain neutral local currency emerging debt. Although we expect the asset class to draw support from an easing of monetary policy in many parts of the emerging world, the outlook for developing world currencies is not yet clear. Lower interest rates, weak demand for commodities and a slower-growing China will weigh on emerging market growth for some time, placing downward pressure on many currencies. We have established underweight positions in the RMB, the COP and the HUF.
Elsewhere, we continue to hold an overweight position in European high yield bonds. To us, the asset class is the standout beneficiary of the ECB’s QE policy. Moreover, with economic conditions in the region improving, speculative-grade companies should experience little difficulty in servicing their debts. Default rates can therefore be expected to remain well below the long-term average. Against this backdrop, the yield spread such bonds offer over Bunds – 160 basis points, above the levels seen in the Summer of 2014 – looks attractive.
Luca Paolini, chief strategist, Pictet Asset Management
