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August 2021

Barometer: No need for evasive action

Even if China is flexing its regulatory muscles and Covid infection rates remain uncomfortably high, equities aren't likely to suffer if the economic recovery continues.


Asset allocation: Maintaining perspective

There is no summer lull for investors this year.  The global economy is powering ahead despite the resurgence of Covid-19 infections while inflationary pressures continue to build, particularly in the US. Then there’s renewed upheaval in China.

The Chinese government’s surprise ban on for-profit after-school tutoring, essentially shutting down the circa USD100 billion edu-tech sector, has raised concerns about an intensification of Beijing's regulatory crackdowns. The latest intervention comes on the heels of cybersecurity investigations of the ride hailing app DiDi and other e-commerce companies, increased scrutiny of overseas IPOs and the imposition of fines and restrictions on some of China's largest e-commerce firms. 

Authorities have also moved to restrict the use of the variable interest entities (VIE) structure – holding companies based in tax haven jurisdictions and designed to allow foreign investors to invest in key sectors such as tech without giving them any operational control.

A positive reading of such developments is that they are a belated response to the breakneck growth of tech-related industries that flourished in the absence of a regulatory framework. Even though such moves would in effect add a permanent 'risk premium' to Chinese stocks and bonds, the should not fundamentally change China’s growth model or the broader investment case for the country's financial assets. 

Nonetheless, a greater degree of caution seems sensible and we feel justified in taking profits in Chinese bonds, which have performed strongly year-to-date.

Fig. 1 - Monthly asset allocation grid

August 2021

asset allocation grid

Source: Pictet Asset Management

More broadly, we retain a neutral allocation across equities, bonds and cash; still, we continue to favour assets that benefit from stronger economic potential, such as European stocks. 

Our business cycle analysis shows that economic activity is picking up strongly across the euro zone, following a sharp deceleration over the last two quarters. Purchasing manager indices remain buoyant, especially in the service sector. Retail sales have meanwhile recovered above the pre-pandemic trend. Bank lending conditions are also easing, which augurs well for future credit growth. Overall, it would seem that European economic growth is more likely to to surpass consensus forecasts than the US, where we are starting to see some signs that its expansion is moderating. Worryingly, second quarter GDP growth came in at just 6.5 per cent on an annualised basis – some 2 percentage points below the consensus forecast.

China’s growth has clearly peaked with industrial production, retail sales and construction all coming in below their three-year average. Even so, we still expect a very respectable 10 per cent expansion in GDP for the year – some distance above the 8.5 per cent consensus forecast. 

Should Beijing’s regulatory crackdowns threaten growth, however, there is some comfort to be taken from our liquidity indicators, which show that China has plenty of monetary fire power. Indeed, we already saw authorities take action in July, when the People’s Bank of China (PBOC) announced a 50 basis point cut in the reserve requirement ratio (RRR); we expect to see more action in coming months.

The US is moving in the opposite direction, with the US Federal Reserve edging into the first stages of a tightening cycle. Notably, at its latest meeting, the US central bank highlighted the improvement in economic conditions and “progress” in the labour market. However, we expect the tightening journey to be a relatively slow one, and for now US monetary policy remains the loosest of all the world’s major economies, according to our models.

One of the clearest signals from our valuation models is that US Treasures now look expensive, particularly when compared to levels implied by the cyclical trends we monitor.

The same applies to US equities. US stocks' price-to-earnings ratio of 21.5 times based on 12 month forward earnings can only be sustained if trend growth is unchanged, profit margins are stable at high levels and bond yields stay low. So far, the recovery in US earnings has been in line with GDP (see Fig. 2), and we think further upside to this year’s corporate profit growth is unlikely in the absence of an upward revision to US GDP growth forecasts.

Fig. 2 - Powered by the economy
Revisions of 2020 and 2021 earnings estimates for MSCI USA versus real GDP growth forecast for US
Asset allocation - earnings estimates.png

Source: Refinitiv, IBES, Pictet Asset Management. Data covering period 18.03.2020-28.07.2021.

Technical indicators suggest the correlation in the returns of equities and bonds has turned negative again, improving the diversification appeal of fixed income.

Another conclusion to draw from our technical gauges is that investors appear more cautious. This is arguably reflected in the strong inflows into government bonds seen in recent weeks, as well as into equity funds that invest in quality stocks. Some USD6.7 billion flowed into tech, healthcare and consumer goods stocks in the first three weeks of July at expense of cyclical sectors, according to EPFR data. Approximately USD3.1 billion was withdrawn from financials, materials and energy stocks in the same period.


Equities regions and sectors: sizzling summer comeback in Europe

Prospects for European stocks are improving as a smooth vaccine rollout allows governments to lift lockdown measures.

The region is now taking the lead in the recovery from the Covid crisis from the US (see Fig. 3), with business activity across the region expanding at its fastest rate in 21 years and mobility indicators having already returned to pre-Covid levels.

At the same time, European stocks should also benefit from what we expect will be an upward move in real bond yields.

That’s because European equity indices contain a greater proportion of value stocks, such as financials, which tend to outperform when real rates rise.

For these reasons, we upgrade the euro zone to overweight.

We also upgrade Swiss equities to overweight. Swiss equity markets are home to a large number of quality stocks, which tend to perform well during the middle phase of a bull market cycle.

Fig. 3 - Europe takes the lead
PAM leading indicators, 3m/3m annualised
Equities - leading indicators.png

Source: Pictet Asset Management, CEIC, Refinitiv. Data from 01.03.2020 to 01.06.2021.

Elsewhere, our models continue to show a “buy” signal for UK stocks.

It is a market with a high dividend yield of 4.2 per cent, more than double the global average, and is also attractively-valued on other valuation metrics.

Also in the market’s favour, the UK economy is expected to rebound to post growth of some 7 per cent this year after suffering its biggest contraction in more than 300 years of almost 10 per cent in 2020.

Next year’s expected growth rate is the same as the US, among the fastest of all major advanced economies.

Despite this, the equity market continues to underperform its counterparts. UK stocks currently trade at a 33 per cent discount to world equities as measured by the MSCI All-Country World Index, the widest since 1992 when Britain was forced to withdraw sterling from the European Exchange Rate Mechanism.

We think the discount will begin to fade away in the coming months.

We remain neutral on equities in China and other emerging markets. Leading indicators in the world’s second largest economy have fallen for 11 months in a row in the latest sign that the recovery is losing steam.

Beijing’s regulatory crackdown on industries such as tech, education and property have also raised concerns about future profitability and could further reduce valuations for high growth sectors.

However, we don’t think a full-scale withdrawal from Chinese stocks is warranted.

The PBOC recently lowered reserve requirements for domestic banks and hinted at a potential shift in favour of looser monetary policy to lower the cost of servicing debt and support growth, which should underpin risky assets in the medium term.

We also stick to a benchmark weighting for Japan, where economic data is disappointing and the pace of vaccinations is slower than other major economies.

The US remains our only underweight position. The S&P 500 index has gained 15 per cent in the first half of this year, thanks to corporate strong earnings. But it is unlikely the index will repeat the stellar performance in the second half, especially when corporate profit margins, already at record highs, will struggle to rise further.

Our models suggest US stocks’ price-earnings ratios will decline by as much as 15 per cent by the end of the year.

There are also worries that inflationary pressures, which are building due to rising prices for Covid-related items such as used cars, could persist long enough to change inflation expectations. This, in turn, could prompt the Fed to scale back its monetary stimulus earlier than the market anticipates.


Fixed income and currencies: taking profits

A powerful bond market rally that drove yields sharply lower has prompted us to take profits on US Treasuries; we have reduced them to neutral from overweight.

Initially, the downward move in yields came in response to signs that US economic growth had started to peak; leading indicators had edged back from highs and made worse by concerns surrounding the Delta Covid variant (see Fig. 4). This seems to have been confirmed by a significantly weaker-than-expected second quarter US growth report.

But there are reasons to believe 10-year Treasury yields, which fell some 40 basis points over the month, are now too low at 1.3 per cent, even accounting for recent loss in momentum in US economic activity. Our valuation models, for instance, suggest a fair value closer to 1.7 per cent and the yield implied by a range of cyclical trades and indicators is even higher still.

Our thesis is further reinforced by the fact that bond rally was partly technical, aided by a unwinding of short positions. A large rump of investors, confronted by positive economic developments and expecting lockdowns to be eased, had chosen to go short fixed income in recent weeks, particularly in Treasury bonds. So when bond yields began to fall, many of those holding bearish positions covered those shorts, adding further fuel to the rally and pushing bond prices to levels where they were at odds with economic fundamentals. 


Fig. 4 - Gapping
US manufacturing ISM index vs US treasury yields, %
FI - US treasury yields vs US Manufacturing.png

Source: Pictet Asset Management, ISM, Refinitiv. Data from 28.01.2010 to 29.07.2021.

With real yields also having hit all-time lows, investors have additional reasons to believe the market is richly valued, particularly at a time when the Fed is seen to be thinking about the first stages of monetary tightening. 

Separately, we also take profits on Chinese government bonds, reducing our exposure slightly but still maintaining an overweight. 

At below 3 per cent for the 10-year bonds, the assets are looking less attractive, particularly given the potential impact on inflows given the Chinese government’s regulatory crackdown this month.

Elsewhere, when it comes to currency positioning, the yen is the cheapest of the G10 currencies according to our metrics, while US dollar strengthening this month has fully covered the market’s short positioning on the currency. Elsewhere, sterling no longer looks overbought.


Global markets overview: bullish but not in China

July was big for global bonds, which ended up some 1.4 per cent during the month, helping them to pare back some of their year-to-date losses. These gains were nearly across the board, with US Treasury bonds, up 1.3 per cent, while gilts picked up nearly 3 per cent in local currency terms. 

But the bond market’s gains didn’t seem to be driven by a generalised flight from risk. Equities performed reasonably well – with a caveat – picking up 0.7 per cent on the month, led by the US, up 2.4 per cent. The caveat was hefty losses in the Chinese market after the government’s crackdown on its privately-run education companies. This dragged down t emerging market assets , though EM Asia stocks took the brunt of the losses, down some 7.5 per cent. Japan also suffered, though there, concerns about a serious wave of Covid also played its part, knocking more than 2 per cent off the market. 

Fig. 5 - Look out below
MSCI China Index
Markets - MSCI China.png

Source: Pictet Asset Management, MSCI, Refinitive. Data from 01.07.2020-28.07.2021.

Growth-oriented stocks far outperformed value on the month, so that returns from these two factors are now neck and neck for the year: value had been a big winner in the first months of 2021. Profit taking knocked back energy stocks, losing more than 5 per cent on the month, though they were still up more than 20 per cent on the start of the year. Materials, health care and IT all performed well.

Despite the bond market’s overall performance, inflation risks are still a worry if the gold and other commodities are anything to go by. Gold was up 3.3 per cent on the month, though the yellow metal’s overall performance since the start of the year has been lacklustre. Oil was up again as were commodities generally.

Unsurprisingly, credit was supported by both the robust bond and equity markets, with euro and US investment grade issues doing particularly well. 


In brief

barometer August 2021

Asset allocation

Balancing the economic resilience with the rising uncertainty, we prefer to retain an overall neutral allocation across equities, bonds and cash.

Equities regions and sectors

We upgrade European and Swiss equities; our underweight stance in the US remains unchanged.

Fixed income and currencies

We reduce US Treasury bonds to neutral from overweight and Chinese government bonds to partial overweight from full overweight on profit taking.