European equities to come out of the shadows

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Prospects for European equities have turned more positive, at least in the short-term, and we have moved to an overweight position.

European economic prospects are looking healthier than they have done for nearly two years. The euro’s exchange rate is competitive and monetary policy should remain accommodative for the foreseeable future – even with the modest scaling back of ECB’s liquidity injections in the second half of the year. The immediate risk of further political upheaval is low.

Based on the combination of relatively cheap valuations and the strong potential for growth, Europe is one of the most attractive equity regions globally.

This valuation metric also supports our positive views on the UK and Japan. Although Japanese stocks are overbought, an improving domestic economy, a weak currency and global reflation should offer the market some strong support.

In contrast, we have turned more cautious on Pacific ex-Japan, a stance that reflects both the possibility of economic turbulence in China and a relatively weak leading indicator for Australia.

Near-term, market euphoria over Trump’s pro-growth proposals could fade somewhat as political realities bite, while China’s slowing economy and mounting debts could induce fresh market turmoil at a time when Beijing is tightening monetary policy as it seeks to stop asset bubbles forming.

Additional interest rate hikes by the Fed – coupled with a steady draining of central bank stimulus worldwide – could also weigh on financial markets, particularly on emerging markets.

Indeed, we note a distinctly hawkish tilt in the Fed’s stance, with the committee’s rate projections shifting higher.

Given the conflicting forces of stronger global growth and tighter liquidity, we remain neutral on bonds and equities… we prefer to stay on the side lines, ready to increase our equity exposure later in 2017.

Because we expect the world economy to enjoy a boost from Trump’s policies, we believe there is scope for cyclical stocks to outperform more defensive sectors. We are more cautious on industrials following the recent rally.

In bonds, we consider that the post-US election shakeout has opened up some value, particularly in US investment grade debt, hence we now have a slight overweight.

Global and particularly US liquidity conditions, along with investor bullishness on Trump implementing much if not all of his promised tax and spending proposals, suggest the prospect of a sudden flight from risk during the coming month or so, which could benefit US bonds, not least because the asset class is the most oversold we have ever seen.

Our preference is for the ultra-long end of the US bond yield curve; we remain underweight the short end which will continue to be sensitive to expectations of rising Fed funds rates.

Expectations of a friendlier regulatory and tax regime under Trump and an improved outlook for corporate earnings have led us to upgrade US investment grade credit to a moderate overweight, the same level as we have for US high yield.

We have trimmed our exposure to local currency emerging market debt due to a combination of factors: persistent dollar strength; flight risk; and, tightening Chinese debt conditions. Also, even if Trump ignites strong US growth, there’s a risk it won’t flow to the rest of the world if he also implements an anti-trade agenda.

Luca Paolini is chief strategist at Pictet Asset Management