US equities may be trading at more expensive multiples than European counterparts, but we think there is still room for the equity market to appreciate.
A Federal Reserve that is unlikely to raise interest rates before December should also help underpin risky assets. Valuations in US stocks are nowhere near bubble territory yet, while those in bonds have reached far more excessive levels.
Europe on the other hand is cheap for a reason – it has failed to address a wide range of growth-sapping structural problems and the region remains vulnerable to political instability ahead of presidential elections in France and Germany. Concerns over Italy’s debt-laden banks could also shake the region. The ECB, which has been the only institution keeping the currency bloc together, may start to run out of ammunition. We are also sceptical about the efficacy of further monetary stimulus in the euro area.
We have raised the score on emerging markets to a single plus. Economic fundamentals have improved as the perceived risk of near-term financial instability in China has receded. There are signs that strong US domestic demand is finally beginning to lift exports in some Asian countries, while Russia and Brazil are beginning to come out of deep recessions.
UK and Japanese allocations remain overweight as we expect further policy stimulus, which should benefit their equity markets. The Bank of England is widely expected to renew its stimulus efforts to head-off a post-Brexit downturn, following a drop in consumer confidence and early signs of retrenchment in key industries. Fresh measures could include a cut in interest rates and more targeted easing. Japan has responded to the shock of Brexit, which triggered a surge in the safe-haven yen that has been choking exporters, with a sizeable stimulus package. According to our model, the valuation of Japanese equities is currently extremely cheap, at some two standard deviations from the long-term average.
Most developed market government bonds remain at extreme valuations. Indeed, some became even more expensive in the wake of the Brexit referendum as investors anticipated further monetary policy stimulus to mitigate the poll’s economic fallout. As a result, we have kept our positioning on these bonds unchanged, staying underweight on all except for US Treasuries. Only the US retains any residual value at the long end, which we view as one of our last safe haven assets. Even the case for long-dated Treasuries isn’t clear-cut after yields collapsed during the month.
The US economy’s fundamentals are increasingly positive. Growth momentum has improved, as has consumption, more than offsetting any weakness in manufacturing activity. Wage growth, meanwhile, has been accelerating. The Fed’s own measure shows wages have been rising at 3.6 per cent a year, which is broadly around the Fed’s target levels.
Nonetheless, the market is ascribing only a 28 per cent probability to a Federal Reserve rate rise in September and only a 50 per cent chance in December. Set against the backdrop of a robust economy, a tight labour market and rising earnings, this suggests the Fed will find itself behind the curve. Policy could end up having to play catch-up to control rising inflation. These factors have the potential to trigger a sharp steepening of the Treasury curve, with Fed policy having ever less traction beyond the short end of the market. One way to mitigate these risks would be to seek protection in the form of inflation-indexed bonds. We have cut our stance on emerging market hard currency debt and US high yield bonds following their strong performance over recent months, reducing the former to neutral and the latter to a single plus from full overweight.
Desperation for yield has sent money flooding to any and every corner of the market offering income, but the case for high yield debt relative to equities is less compelling after the yield gap between US equities and US high yield has fallen to 1 percentage point from 3.7 in February. Now is the time to start taking profits.
We have made no changes to currencies. We keep our underweight stance on the yen, which remains vulnerable to a large Japanese stimulus package.
Finally, we continue to overweight gold bullion as a long-term hedge against significant monetary debasement, which seems an inevitable ultimate consequence of ever more aggressive central bank policy. Especially now that experiments in direct monetisation of fiscal spending no longer seem to be anathema to policymakers.
Luca Paolini, chief strategist at Pictet Asset Management