“World equity markets look overbought and we have dialled back risk by cutting our exposure,” says Luca Paolini, chief strategist at Pictet Asset Management. “Valuations for developed market stocks and bonds look stretched as corporate earnings growth remains sluggish and US liquidity conditions seem to be worsening.
Emerging market and Japanese equities are the most attractively valued, and we retain overweight positions in both. This is justified by the fact that, whilst emerging equities have recovered significantly from February, inflows are rising and there are signs that Chinese growth is bottoming out. We also expect to see a modest improvement in economic growth momentum and moderate export growth.
Japanese equities are supported by the ongoing liquidity injection by the BOJ, which may ease policy further at the very end of this year. The weak JPY is boosting corporate earnings. The Japanese market offers scope for further gains as it is trading close to its deepest ever discount to world stocks.
US equities are not appealing. Although economic and corporate earnings growth look good and the central bank is accommodative, the recent rally has taken valuations to excessive levels. In addition, corporate margins are likely to fall from record levels.
With market volatility at historic lows, investors might have become too complacent about risk. In particular, we think that investors are too sanguine on the Fed exit strategy, as inflation risks in the US are underestimated. We expect US core PCE inflation to rise by about 0.5 percentage points to 2 per cent by the year end.
That is not to say the bull run has come to an end; rather, we expect to see a temporary setback that should provide investors with a better entry point. Future equity gains are increasingly dependent on growth in corporate earnings, which has remained elusive, or a further decline in bond yields, which we think is unlikely.
We are also cautious on European equities which are very expensive, economic growth is slowing and corporate earnings remain sluggish.
Supply and demand conditions in high-yield bond markets could become less favourable over the coming months. Inflows have moderated and this will persist throughout the summer. Persistently high levels of high-yield bond issuance should also exacerbate imbalances in supply and demand.
We have raised our exposure to US dollar emerging market (EM) corporate bonds. In contrast to developed market corporate bonds, valuations for EM company debt remain attractive. For an asset class that is predominantly investment-grade, a yield of just above 5 per cent is compelling at this point in the economic cycle."
