Luca Paolini, chief strategist at Pictet Asset Management, examines the risks to the asset class.
Despite the equity market’s recent rally, the upside for stocks is limited in the short term – even if economic conditions appear to be improving.
That is because stronger growth would inevitably lead the Fed into scaling back its asset purchase programme (we still believe ‘tapering’ will start by December at the latest), removing the main support for risk assets. Conversely, a slowdown in growth would trigger further corporate earnings downgrades, which would also weigh on stocks.
Equities should, therefore, trade in a range until the end of the summer. Although growth appears to be accelerating and central banks continue to provide stimulus, lofty valuations and the unusually high levels of investor complacency shown in sentiment readings suggest a market correction cannot be ruled out.
Why optimism on equities is premature
That said, we expect equities to outperform fixed income in the next three months as there are many risks facing the asset class.
These include the prospect of better economic growth, Fed tapering, a potential rise in sovereign risk in the eurozone in the lead-up to German general elections and unattractive valuations – all of which make for a challenging environment for government bond markets. We have, therefore, re-entered an underweight position in government debt.
In our regional equity portfolio, we maintain our long US/short Europe position. While we see some encouraging signs in Europe, especially economic growth, these are not yet strong enough to compensate for the risk of political upheaval: September’s election in Germany could prove to be a watershed event for the eurozone.
In USD terms, European equities have lagged their US peers by around 10% year-to-date and we expect them to continue to underperform. We still believe that the 15% discount offered by European equities relative to their US counterparts is fully justified.
Furthermore, we predict US equities to benefit from a stronger US dollar, an accelerating economy, sound corporate earnings and a private sector that is in good shape after reducing its debts by a greater margin than any other major developed country.
While fundamentals for Japan appear equally attractive, the market’s exceptionally strong rally has made it an expensive option. On the other hand, emerging markets continue to underperform.
Valuations are becoming very attractive, especially in Asia (China and Korea are trading below 9x projected earnings) but continued capital outflows coupled with sluggish economic and corporate earnings growth prevent us from adopting a more bullish stance on the market.
On sectors, we believe an improvement in global leading indicators and rising bond yields strengthen the case for adopting a more cyclical bias, as cyclical stocks tend to do well in periods when bond yields are rising.
Based on valuation, we maintain our overweight position in healthcare, which is relatively insulated from the negative impact of rising bond yields, and continue to hold a higher-than-index exposure to technology.
Meanwhile, we expect industrials to be the biggest beneficiary of a recovery in investment spending and have, therefore, shifted to an overweight in that sector.
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