Barometer: Slim pickings outside emerging markets
Asset allocation: In the face of continued macro uncertainty, we upgrade bonds to overweight and remain negative on equities.
Equities regions and sectors: Emerging markets should benefit from a widening growth gap with developed peers. We stay defensive in our sector positioning.
Fixed income and currencies: We downgrade Japanese government bonds because of robust domestic growth.
Asset allocation: equities remain too risky
As spring blooms in the northern hemisphere, the green shoots of economic recovery appear to be emerging. This after months of stubborn inflation and banking sector turmoil. Unfortunately, however, there aren’t yet enough of those green shoots to convince us to shift from the cautious stance we have maintained since the end of last year. Economic prospects are still highly uncertain, particularly in the developed world thanks in large part to sticky inflation.
Moreover, corporate earnings estimates are being revised down, as we predicted. We continue to forecast flat earnings per share growth for 2023 in developed markets, which is now largely in line with consensus, but we believe expectations for the years to come are still too high. We therefore remain underweight developed market stocks and upgrade global bonds to overweight.
Our global business cycle indicators are still firmly in neutral territory; they are some way off from turning positive.
We still believe the US can avoid a recession, but its growth prospects aren’t especially bright in the medium term. GDP grew by just 1.1 per cent in the first quarter on an annualised basis – around half the pace that economists had expected.
There are some green shoots: our US lead indicator had shifted into positive territory for the first time in nearly a year, while housing activity, which tends to lead the economic cycle, has picked up from 10-year lows. But we believe that a definitive positive shift is still some way off given the lag in the transmission of tightening monetary policy, which has taken longer to work through the economy than in previous cycles. Consumption growth and non-residential investment will surely slow, while core inflation remains stubbornly high.
Our indicators for Europe are equally downbeat; we believe the region is several months behind the US in the cycle. Recent rate hikes won’t be felt in economic activity for another few months, although solid domestic demand should act as a buffer.
The picture is brighter for emerging markets. First quarter GDP data showed Chinese growth back near potential, fuelled by a rebound in private demand, especially in services. We expect excess savings – worth some RMB5 trillion – to be drawn down over the next two years, giving a significant boost to consumption. Property markets also look healthier: construction has rebounded from September lows, floor space is increasing, and mortgage rates have fallen 150 basis points from their peak. China's trade balance has also markedly improved, driven mainly by trade with the ASEAN economies. Our analysis shows that exports are now 63 per cent above pre-crisis levels, led by shipments of electric vehicles.
Our liquidity indicators are positive for emerging market assets but contain red flags for developed market equities. China’s central bank remains in easing mode, encouraging the flow of money and credit into the economy and thus creating supportive conditions for riskier assets.
In contrast, the rate hikes delivered by US and European central banks are now starting to weigh heavily on the cost and availability of credit, causing a marked reduction in liquidity. With more tightening likely, conditions could worsen. Private liquidity – that provided by banks and other private sector lenders - was weakening even before the March bank failures and has now deteriorated further. Net interest margin pressures, tighter lending standards and the likely introduction of more stringent regulatory measures are curbing banks’ willingness to lend (see Fig. 2). Euro zone bank lending has come to a standstill, while in the US it’s slowed to just 1.5 per cent of GDP, compared to an average of 4 per cent in both regions in 2022.
Equities regions and sectors: China boosts EM premium
Some four months after China’s suddenly removed all Covid restrictions, our indicators show growth is picking smartly across its provinces and industries, reinforcing our overweight stance in Chinese stocks and in emerging market equities more broadly.
Our leading indicator for China is well above its three-year average and at a one-year peak, while factory activity stands at its highest level since December 2010.
Domestic consumption is also likely to experience a rebound, thanks to households’ large cushion of savings and a recovery in property markets.
What is more, China’s trade balance has improved, thanks to a pick-up in exports to its southern Asian neighbours. An accompanying recovery in trade with the US – exports, measured by nominal value in US dollars, are now close to their pre-Covid 10-year trend - and continued growth in overseas sales of high-tech products such as electric cars and solar panels also contributed to a stronger trade surplus.
Thanks to a buoyant China, we expect emerging markets to maintain their economic growth advantage over developed peers. We expect the GDP growth gap, which currently stands at 3 percentage points in emerging markets' favour, to widen to a 10-year high of 5 percentage points by the middle of this year.1
The positive gap will lead to superior corporate earnings growth across the developing world, and therefore higher returns for emerging stocks. We forecast a 11 per cent rise in earnings growth for emerging markets this year – broadly in line with the consensus -- compared with near zero in the developed world.
The enthusiasm we have for emerging market equities doesn’t extend to developed markets, however.
We’re neutral across all developed stock markets except for the euro zone, where we have an underweight position.
Euro zone interest rates can be expected to rise further in an economic cycle that, by our calculations, trails that of the US by six months.
The recent appreciation of the euro should also begin to hurt European exporters and weigh on their earnings.
We think valuations for European stocks now fully discount all the positive factors that have helped the market outperform in recent weeks, such as the avoidance of an energy crunch and the re-opening of China. The region's stocks will, therefore, struggle to deliver positive surprises from here.
When it comes to sectors, we prefer to remain defensive at a time when companies are struggling to deliver earnings growth in a slowing economy.
We reinforce this position by initiating an overweight in consumer staples companies, which tend to perform well in a disinflationary environment and when bond yield fall. The sector also benefits from a pick-up in growth among emerging market economies.
We’re also overweight the healthcare sector, which should see an end to earnings downgrades.
We like communication services, too, as it is the only sector that has seen earnings forecasts rise and one that also offers exposure to companies that fall into the category of “quality growth'. This is the label we give to profitable companies with low leverage and high visibility of future earnings - firms that tend to do well even when economic conditions are lacklustre.
Our underweight position in real estate remains unchanged given uncertainty surrounding the commercial property market; the industrial sector also warrants an underweight stance because of its sensitivity to weakening economic growth and our expectations for an imminent slowdown in capital investment.
Fixed income and currencies: defensive duties
With the squeeze on global liquidity likely to prove a drag on the performance of riskier asset classes, we maintain our preference for sovereign bonds. Market expectations had grown unrealistic about how soon the Fed might halt its tightening programme and start easing again, leading to a big rally in the market and prompting us to reduce our positions on a tactical basis. But with a recognition that inflation isn't coming down as fast as hoped, some of the froth has been blown out of the market. That allows us to shift back to an overweight in government bonds, on a more medium-term view that bond yields would grind lower through the year.
We remain overweight US government bonds. This is primarily because inflation dynamics in the US are more benign than elsewhere in the developed world. The continued overweight stance on Treasuries is also on defensive grounds – they remain the safest haven during economic accidents.
The major exception to our overall stance is Japanese government bonds (JGBs). Inflation and solid growth are likely to push the Bank of Japan (BOJ) to at long last reverse its ultra-easy monetary policy, which is why we shift to underweight on JGBs from neutral. We think that the BOJ's policy of yield curve control is incompatible with the economy’s strong positive momentum and the fact that inflation is likely to settle above historical average.
UK government bonds look cheap, but we remain wary that the Bank of England will be reluctant to sufficiently address inflationary pressures, raising the risk of a policy mistake. Our credit allocation remains defensive: we are overweight US investment grade and underweight both European and US high yield paper. We think the banking crisis that started in the US, will run for some time yet. Small banks are still subject to the same pressures that precipitated the crisis and high frequency data reflect a hefty contraction in credit. This makes the recent rally in high yield bonds look fragile.
We remain positive on emerging markets as an asset class generally and, in particular, retain our overweight on EM ex-China Local Currency bonds. The region should benefit from a weakening US dollar, favourable EM-US growth differentials, and improving inflation dynamics. Furthermore, China’s reopening is a tailwind for the whole of emerging Asia.
We remain bearish on the dollar, though we have a defensive tilt in currencies, preferring to stay overweight in traditional havens like the Swiss franc and gold. At the same time, however, we acknowledge that the valuation case for gold is now challenging following its recent rally. Meanwhile, although we are optimistic on the Chinese economy, economic momentum has yet to materialise as yuan strength and we remain neutral on the currency.
Global markets overview: financials recover
Global equities moved higher in April, adding 1.4 per cent on the month, in local currency terms, to take their gains since the start of the year to 8.7 per cent.
The strong performance in part reflected a rebound in financial stocks, as concerns about a structural banking sector crisis – which has blighted performance in March – temporarily abated. Investors took the view that the March bank turmoil did not represent an imminent threat of recession or a credit crunch, in part reassured by stronger-than-expected US bank earnings. This enabled financials to finish April 3.2 per cent higher, reversing part of the previous month’s 7 per cent plunge.
Energy stocks also fared well, reflecting better-than-expected earnings. According to Refinitiv, all of the energy companies in the S&P which have reported first quarter earnings to-date have beaten consensus forecasts, albeit starting from a low bar.
Aside from energy and banks, the rest of April’s equity gains were mainly concentrated in defensive sectors, reflecting lingering concerns about the health of the global economy. Healthcare, consumer staples and utilities all performed well. In contrast, more cyclical sectors such as consumer discretionary and tech finished the month in the red.
Regionally, some of the best performance came from Europe and Japan. US equities also made headway, although the gains in the S&P 500 were driven by just a handful of heavyweight stocks. Over 80 per cent of the US benchmark’s gains so far in 2023 have come from just seven companies, including Apple and Microsoft, according to Bloomberg data.
In fixed income, it was another volatile month, leaving global bonds in aggregate broadly flat. Although the yield gap between 2- and 10-year Treasuries flattened through the month, the curve remains steeper than it was at the onset of the banking crisis. Treasury-Bund spread, meanwhile, tightened to 110bps, bringing it in line with fundamentals.
Emerging market debt fared relatively well, thanks to a relatively strong macro outlook. This pushed valuations up to 2-year highs, according to our models. A more sanguine mood over the banking sector, meanwhile, helped high yield credit markets, both in Europe and the US.
Elsewhere, gold prices briefly flitted above the psychologically key USD2,000 an ounce level, scaling a one-year peak thanks to expectations that the Fed is close to the end of its tightening cycle and its safe-haven status. The dollar lost some ground (see Fig. 5), with its weakness particularly pronounced against European currencies.