“We have also downgraded bonds to a single underweight because we believe the market’s inflation expectations are too low.
Europe and Japan remain our preferred equity markets - earnings prospects look most positive in these regions. The US is expensive while emerging markets are not yet a ‘buy’.
European and Japanese stocks remain attractively priced compared to those in the US, and this valuation gap could potentially see many European firms become takeover targets for US companies, which would provide an additional boost to the region’s stock market.
Japan’s macroeconomic outlook is also supportive of stocks. While the economy entered into a technical recession in the third quarter, a rebound in export volumes and consumer confidence point to a recovery.
In terms of sector weightings, we are maintaining a moderate tilt towards cyclicals with an overweight stance on information technology and financial stocks – the sectors most likely to benefit once US rates start rising.
We have increased local currency emerging market debt weightings to neutral as they may have seen off the worst of the turbulence.
We have lowered exposure to emerging corporate debt to lock in gains encouraged by the healthy returns the asset class has delivered this year, although we believe developing world corporate bond issuers are not as vulnerable to the strong US dollar as some fear.
The US’s first interest rate hike in some 10 years is unlikely to be followed by an aggressive round of monetary tightening, which means the scene could be set for a recovery in some emerging market currencies.
We have positioned for this by scaling back many of our short positions in EM currencies and by increasing our exposure to local currency emerging sovereign bonds from underweight to neutral. With yields of some 7 per cent, valuations are beginning to look attractive.
We are gradually building exposure to the markets worst hit by the sell-off – Brazil is one local currency bond market that might soon recover. Its recent woes – rising inflation, weak growth and a credit rating downgrade to junk status – are more than sufficiently discounted in the price of its debt, now yielding some 15 per cent.
Still, for us to shift our stance to overweight, we would need to have greater clarity on the trajectory of US interest rates as well as evidence of an improvement in emerging market growth.
Elsewhere, we remain overweight US and European high-yield bonds. Default rates among issuers of sub-investment grade debt are low and likely to remain so as the ECB prepares to expand its quantitative easing programme.”
Luca Paolini, Chief Strategist, Pictet Asset Management
More Information: Pictet Asset Management Parometer (PDF)
