Asset allocation: prudence prevails
At the start of 2020, there are grounds for investors to be optimistic. The global economy is stabilising as US-China trade talks are making progress and political clouds in the UK clear.
However, risks remain. Both the trade dispute and Brexit are far from being fully resolved, economic growth is yet to pick up convincingly and the turn of the year is often accompanied by increased market volatility, as well as tighter liquidity conditions. We thus remain neutral on equities, overweight cash and negative on bonds.
Drilling deeper into the individual asset classes, we have a preference for emerging markets (EM) – both in equities and in fixed income. This view is supported by our business cycle model, which suggests that growth in developing countries will continue to outpace that of developed ones. Our leading indicators are rising faster in EM, and manufacturing activity levels are higher. China may no longer be the de-facto EM growth engine, but its authorities have ensured that the country isn’t too much of a drag either: two years of stimulus have filtered through into the real economy and succeeded in stabilising business conditions.
Elsewhere, there are some early signs of improvement in Germany thanks to a rebound in export orders, while the US remains very much a game of two halves – upbeat consumers versus cautious corporations, who are worried about trade as well as upcoming presidential elections.
Even ample liquidity – both from the US Federal Reserve and from the private sector – has not been enough to encourage US companies to ramp up investments, and we do not expect this to change any time soon.
The arguments against shifting to overweight equities are reinforced by our valuation model, which shows global equities are becoming a little expensive. The price-to-earnings ratio on the MSCI All World index has climbed to 16 times at the end of 2019 from 14 times at its start. However stocks still look more attractive than bonds (see Fig. 2), which are extremely expensive in both relative and absolute terms.
Within equities, the UK is by far the cheapest region – a valuation gap which we think might start to close following the decisive election victory by the Conservative party.
Technicals suggest that light investor positioning in UK assets is a reason to expect them to rally further. On a global level, though, our readings indicate investors should take a more cautious stance. Realised volatility has picked up from very depressed levels while the steepness in the curve makes it expensive to buy options to protect against any market swings.