This is an extract from our Asset Allocation Monthly for May
Hopes for sharply higher profits may be justified given the multi-trillion dollar stimulus in the US, but there is also concern that higher taxes may limit earnings growth. This comes at a time when most markets are highly valued; not just the US. While low interest rates and inflation warrant a valuation premium over historical averages, some normalisation seems likely.
How will a normalisation occur?
There are two scenarios: Either a steep fall in equity prices or a more rapid increase in earnings than in prices. We believe the latter is more likely. Normal market volatility could provide a better entry point for investors. Our market temperature indicators signal that such a time may not be far off. So, which catalyst could trigger the volatility?
One driver could be the US economy overheating and inflation expectations rising sharply. This could trigger policy rate increases. Another possibility is that tax increases become a larger part of the Biden administration’s plans, dampening investor sentiment and corporate profit growth.
Given the high market prices, earnings will need to at least match analyst expectations to support current valuations. So far, that has been the case. This bodes well for the market as vaccination rates rise, more countries come out of lockdowns and pent-up demand is fulfilled. The corollary, though, of the need to beat earnings forecasts is that stocks suffer harshly if results fall short of forecasts.
Time to switch into European equities?
The strong performance and high valuations of US equities have prompted some investors to consider a move into European equities to capture the next leg of the re-opening trade.
European value stocks have underperformed US value by about the same amount as European growth stocks have outperformed US growth, with the net effect being slightly lower returns for Europe since last November. European equities have benefited from being more cyclical and value-oriented, while US equities have profited from fiscal stimulus.
We are currently overweight US (value) equities, but the prospect of higher interest rates and taxes in the US, when relative valuations remain in Europe’s favour, could yet tip the balance.
Or into emerging markets?
We expect emerging market equities to outperform developed markets given EM’s cyclical nature, reduced trade tensions between the US and China and a weakening US dollar.
The risk is that rising US interest rates make EM investments less attractive, but foreign portfolio inflows have been strong.
Furthermore, Chinese growth, which is a key determinant of emerging market growth, remains robust, though the government faces challenges to support the economy while simultaneously seeking to cut debt in the economy.
Fixed income – Cautious on duration
The outlook for inflation remains an important topic. The US Federal Reserve has reiterated that a near-term rise in inflation is not a concern and indicated that it will not taper its asset purchases or raise policy rates as soon as the market expects. Anecdotal evidence, however, suggests wage pressures are building as the labour market recovers.
Real interest rates are, for the time being, contained thanks to the Fed’s go-slow messaging. We expect tapering to begin by the first quarter of next year, with policy rate increases following by 2024. As the market anticipates tightening, we should see inflation-adjusted rates increase. Hence, we remain cautious on the outlook for duration.
Eurozone inflation expectations have risen by nearly as much as in the US, perhaps by too much. A boost to demand from the removal of lockdown restrictions later this year will likely not be accompanied by the same level of fiscal support as in the US. As a result, we are less upbeat on the outlook for eurozone inflation.
In summary – Our asset allocation
We see a strong global recovery anchored by progress on vaccine rollouts and economies reopening, a large US fiscal expansion, and easy monetary policy supporting risky assets over the medium term. So far, the US has led the bounce, but growth in other major economies should accelerate.
Despite a short position in Eurozone equities, our net equity exposure remains long via US value, EM equities, Chinese equities and Japanese equities. We are long risky assets such as commodities and EM local debt. Portfolio diversifiers include gold and European real estate investment trusts.
We remain long EMU small caps. They are likely to outperform in an economic recovery on the back of being high beta and having more attractive valuations relative to large caps.
We see further upside scope in eurozone bond yields in the medium run, but we would look for better entry levels to re-establish shorts. We are long EM local currency debt since we see room for yield spreads to narrow and for currencies to appreciate as the US dollar comes under pressure due to its high valuation and the prospect of an acceleration in growth outside the US.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.