“Riskier assets classes, particularly equities, continue to draw support from reasonable global economic growth and continued monetary stimulus. Investors should be wary for several reasons.
“First, the equities rally is losing steam. Second, economic growth appears to have plateaued. Third, central banks are slowly but steadily preparing for a winding down of some monetary stimulus measures.
“The onus is now on equities to justify their strong performance after a spectacular run, with suitably strong earnings numbers. Expectations are running high, particularly in the US in turn raising the risk of disappointment.
“The consensus view on US earnings implies real GDP growth in excess of 3 per cent – which has not been seen in over a decade. This is in stark contrast with economic realities.
“Hence, we remain neutral on equities and underweight on bonds. We do see attractive investment opportunities within each asset class, nonetheless, such as European stocks and US Treasuries.
“Both Europe and Japan are favoured over the US, with economic and earnings cycles converging. Prospects for euro zone equities look particularly bright thanks to improving economic prospects; we also like UK equities – they offer a sizeable dividend yield while the market’s multi-national constituents earnings should draw some support from a weak pound.
“Japanese stocks, meanwhile, boast attractive valuations relative to the US, underpinned by a still very expansionary BOJ. Emerging markets equities offer long-term value and should benefit from a weaker US dollar, but they look a little overbought after the rally and strong investment flows. Thus, we retain our neutral stance.
“We have trimmed our exposure to cyclicals in line with the deterioration in global growth. Telecoms, energy and financials stand out as offering best value, but we’re prepared to cut exposure if the global economy shows further moderation.
“The Fed faces a dilemma: substantial falls in US inflation will be hard for the central bank to ignore as it mulls further monetary policy tightening, as recently reinforced by comments from Yellen, alongside weakness in business and consumer lending. This is in part behind our decision to upgrade US Treasury bonds to overweight from neutral.
“Elsewhere, we remain underweight euro zone, Japanese, Swiss and UK bonds, all of which look expensive. We are still overweight in emerging market local currency bonds –economic activity remains solid and inflation is slowing, allowing an easing of monetary policy. Any further drop in US Treasury yields and the dollar should also support local currency debt.
“We retain our underweight stance on the dollar – it has already dropped 10 per cent from its highs and has further to go. EM currencies are well-positioned to benefit from dollar weakness. The ECB looks uncomfortable with the euro’s appreciation and whilst we retain our overweight, we’ve reduced our position on the Swiss franc, a euro proxy, from overweight to neutral.”
Luca Paolini, chief strategist at Pictet Asset Management