Liquidity drain erodes equities
Global equity markets are caught between two opposing forces. Improving macroeconomic fundamentals are being supportive whilst increasingly negative liquidity conditions are negative. With monetary stimulus set to wane, we retain our neutral stance on equities.
Liquidity has been a critical support for asset prices over recent years. It is unclear which factor – fundamentals or liquidity – will dominate over the long-run. For now, there is enough variation in macro-economic and liquidity conditions – not to mention valuations – across regional equity markets and stock sectors to open up a number of tactical investment opportunities.
Japanese equities in particular look cheap, especially considering the market is trading at a lower P/E ratio than Brazil for the first time ever. What is more, if global bond yields rise in line with our forecasts, Japanese stocks should be expected to rise too. If bond yields ratchet higher because global economic conditions are improving then, Japanese companies, among the world’s top exporters, should benefit disproportionately from that acceleration in growth.
Elsewhere, the UK stock market’s growth prospects have been given a boost by sterling’s dramatic depreciation since the EU referendum. Although Brexit is still more theory than reality, negative headlines have been met by sharp currency moves. Sterling’s dollar exchange rate is now about 30 per cent below fair value. Around 70 per cent of the revenues generated by firms in the FTSE 100 index come from overseas.
Overall, we remain overweight both the UK and Japanese equity markets and neutral on other regions. Whilst markets remain relatively well behaved, the combination of moderate growth and rising bond yields could lead to further outperformance by cyclical sectors at the expense of defensive sectors trading at high valuations such as staples.
That’s surprising because both might be expected to suffer from the withdrawal of central bank support for the markets. But we think most of the pain will be felt by defensive stocks with bond-like characteristics, like utilities. Cyclical stocks should be further supported by their relatively low valuations.
That’s not to say we see no value in defensive sectors: telecom and pharmaceutical stocks are attractively valued and under-represented in investment portfolios. We have also upgraded financials to overweight from neutral, due to positive macroeconomic developments, which should support credit demand, bullish momentum indicators, a gradual steepening of yield curves, which can boost lending spreads, and cheap sector valuations.
Investors who have piled into US high yield bonds over the past few months have been richly rewarded. High-yield bonds’ spread over US Treasuries, meanwhile, has narrowed since hitting a peak in February. Having held an overweight position in the asset class over most of 2016, we believe it is now time to scale back our exposure to neutral, primarily due to valuations.
Elsewhere, we continue to hold a neutral position in emerging market debt – for both US dollar and local currency bonds. The prospects for emerging market currencies look less compelling in wake of the strong run many of them have enjoyed since the beginning of the year. These currencies could reverse course if demand for US dollars eclipses supply in the coming months and commodity price rally peters out.
Luca Paolini is chief strategist at Pictet Asset Management