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January 2020

Barometer: Not getting carried away

The global economy appears to be on a more stable footing at the start of the new year. But investors should guard against complacency


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.

Fig. 1 Monthly asset allocation grid

January 2020

Pictet asset allocation grid

Source: Pictet Asset Management

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.

Fig. 2 Stocks unusually cheap vs  bonds
Global equity earnings yield minus global bond yield, ppts
Yield: equities vs bonds

Source: MSCI, JP Morgan. Data covering period 01.09.1998 to 31.12.2019.

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.

Equity sectors and regions: bullish on the UK

Political tensions appear to be lifting. The US and China have reached a limited trade deal while an overwhelming election victory for UK Prime Minister Boris Johnson raised hopes for an end to the Brexit deadlock. The first development is particularly positive for emerging market stocks; the second for UK equities.  Which is why we are maintaining our higher-than-index allocation to the former and upgrading the latter to overweight.

The UK led a year-end rally in global equity markets as optimism grew that the world’s fifth largest economy would follow countries such as Japan, Korea and India in expanding fiscal stimulus to support growth.

In our view, the UK market’s outperformance should continue. International investors are under-invested in UK stocks and we expect them to raise their allocation in the coming months as political tensions ease. At the same time, we also believe UK companies could become acquisition targets for overseas firms. 

Fig.3 Due a bounce: UK stocks to close gap with global peers
Global equity market performance relative to UK, total return in local currency, and trade-weighted sterling index
UK equities and sterling chart

Source: Refinitiv. Data taken from MSCI UK and MSCI World Indices, covering period 01.01.1991 to 31.12.2019.

UK companies are among the most attractively valued in the world according to our scorecard, with a price to earnings ratio of 14 times. Their dividend yield of 5 per cent, meanwhile, is twice that of the MSCI All Country World index.

Also, the industry breakdown of UK indices means investors can gain greater exposure to sectors we favour at a global level: cyclical value stocks such as banks and quality defensives such as pharmaceuticals. 

The UK aside, the only other equities we find attractive are EM stocks. Developing economies continue to have better growth prospects than those in the developed world. The region’s inflationary pressures are muted – in many cases inflation is below the 20-year average. What is more, EM companies should benefit further from a weaker dollar, as well as expected fiscal and monetary stimulus from China in the coming months.


Fixed income and currencies: EM's attractions multiply

Much of the fixed income universe may looks worryingly expensive, but there is value in the shape of EM bonds. So while overall we are underweight fixed income, we remain positive on EM debt.

A handful of  factors underlie our stance. First, we expect consumer price pressures in EM economies to continue easing. Indeed, the inflation gap between the emerging and developed world has been shrinking for many years – which will allow EM central banks to cut rates further in the coming year.

Meanwhile, EM governments have tended towards fiscal prudence, reducing the likelihood of inflationary blow-outs. Second, EM real bond yields are almost 300 basis points above those of developed market bonds, compared to a long-run average of between 150-200 basis points, suggesting scope for further gains. Third, EM currencies look cheap against the dollar. We expect the greenback to lose ground next year which, in particular, should be a spur to EM local bonds.

Fig. 4 Inflation genie back in the bottle
Annual inflation in emerging markets, 2020 consensus forecasts vs central bank targets,  %

Source: Pictet Asset Management, CEIC, Refinitiv, Bloomberg - all as of 30.11.2019

We are particularly positive on Mexican and Russian bonds. In both countries, growth is accelerating, primary government budgets are in surplus, debt to GDP levels are among the lowest in the world, inflation has fallen well below 4 per cent while official rates are around 7 per cent. Elsewhere, prospects for a cut in China's interest rates are rising, given some of the gloomy data coming through – with easing likely to come ahead of Chinese New Year celebrations.

We remain wary of the credit markets. Spreads on such bonds are paper thin, which is to say investors don’t have much of a buffer against negative surprises. For instance, if, say, the trade war were to heat up again, defaults could well start to rise. Alternatively, economic strength against a backdrop of capacity constraints could yet trigger inflationary pressures, which would also make bonds fall out of bed.

In the currency markets, we continue to favour sterling. The pound has gained some ground since the summer’s lows, but it remains cheap compared to the UK's economic fundamentals. Investors also remain under-invested in the currency. All of which means that any progress in the UK's trade negotiations with the European Union could inspire a significant rally.


Global markets overview: a stock market bonanza

Equities had a banner year in 2019, with global stocks making further gains in December to take their annual performance to nearly 27 per cent – the best result in a decade (see Fig. 5). 

Investor sentiment in December was boosted by Britain’s Conservative party securing a strong majority, which eased some uncertainty over Brexit, as well as by signs of progress in the US-China trade negotiations.

Information technology stocks delivered the best returns both for the month and for the year. Despite weakening fundamentals, such as sales figures, investors took the view that technology has strong long-term potential for growth.

Energy shares also fared well in December, adding 4.1 per cent as an OPEC-plus agreement to cut production by an extra 500,000 barrels a day sent crude prices higher.

Emerging market stocks rose the most on the month, with the Brazilian bourse hitting record highs. But that was not enough to unseat the US from its spot as the  best performer of the year; the S&P 500 ended up almost 32 per cent.

Fig.5 A decade high
Global stocks, year-on-year return in local currency terms, % (MSCI World All Country Index)
Equity markets chart

Source: MSCI. Data covering period 01.01.1989 to 31.12.2019.

Global bonds finished December slightly lower, trimming their 2019 gains down to 6.1 per cent. Developed market sovereign debt lost ground during the month. Instead, investors favoured the higher yields offered by emerging markets and corporate bonds.

The dollar lost ground across the board in the final month of the year, down 1.9 per cent against a basket of currencies. The Mexican peso, Brazilian real, Russian rouble and South African rand all made strong gains. Sterling also performed well, adding 2.4 per cent versus the US currency as general election results were seen to reduce political uncertainty. The Turkish lira was a notable outlier, weighed down by tense relations with the US administration over Syria and looming sanctions.


In brief

barometer january 2020

Asset allocation

We remain relatively cautious, with an overweight on cash, a neutral position on equities and an underweight stance on bonds.

Equities regions and sectors

UK equities look attractive after the election. We also turn more positive on financials.

Fixed income and currencies

Although we remain cautious on fixed income in general, we continue to overweight emerging market local debt. We also favour EM currencies and sterling