“The recent improvement in the region’s monetary aggregates and a weaker currency suggest that the risk of deflation - which now appears to be a consensus expectation - may be overstated. Moreover, the ECB’s programme to buy asset-backed securities and covered bonds is a last step before full-blown quantitative easing.
If these more targeted measures disappoint, there are indications that the central bank will consider large-scale government bond purchases - but even if the ECB were to refrain from QE that would not necessarily be negative for stocks as it would suggest that economic conditions are improving.
Although valuations for European stocks are not yet particularly compelling, this is mainly due to the fact that corporate earnings levels remain unusually low at this point in the cycle.
We still favour cheap cyclical stocks, and have built overweight positions in the energy, materials and industrials sectors. The energy sector has corrected in tandem with the sharp decline in the oil price this month, and is now cheap and shows the potential for a rebound, particularly as increased geopolitical risk continues to raise the prospect of possible disruptions to production.
Emerging markets have also seen their currencies fall against the USD in recent weeks which will improve their export competitiveness at a time when external demand is rising. Valuations are still supportive for emerging stocks, even if the discount at which the asset class trades to developed markets has narrowed. These positives are tempered by weak economic momentum and capital outflows from equity investors, however.
Our cautious stance on the US reflects our concerns over slightly unfavourable liquidity conditions and lofty valuations which pose some risks, particularly at a time when the Fed is withdrawing monetary stimulus. We retain neutral on Japan - stocks are trading more or less in line with the broader market.
Elsewhere, the appeal of local currency emerging market debt is growing as valuations for both bonds and currencies drift to levels that are at odds with such countries’ longer-term economic prospects. This is especially true of emerging market currencies, which in aggregate are trading some substantially below fair value.
Hence, we have consequently shifted our stance on the asset class but remain selective. The Brazilian real and the Turkish lira are among the currencies that exhibit the strongest potential for a rebound in the short term, in our view, while currencies such as the Russian rouble remain hostage to geopolitical risks.
Valuations for certain bond markets are also extremely attractive. Peso-denominated Mexican government bonds look especially appealing. To fund this position, we have reduced our exposure to emerging corporate debt to neutral from overweight. This reduction in part reflects our concerns over trading conditions in the market – liquidity is not as favourable as it once was.
Liquidity also appears to be deteriorating in other parts of the corporate bond market, especially within high-yield debt, where there is a growing imbalance between the volume of securities in investment funds, which continues to grow, and the inventories held by market-makers in the asset class, which are heading in the opposite direction.
We are now neutral stance across all credit categories as we have generally become more cautious on global credit risk. Elsewhere we have locked in some gains on a number of long-held currency positions; for example, reducing our underweight on the JPY versus the USD by some considerable margin following the currency’s recent depreciation.
Looser monetary policy should, however, have less of an effect on euro zone government bonds, particularly those of Italy and France, which are already trading at expensive levels.”
