Waiting for the catalyst
We believe that the stock markets will outperform in the coming months. The risk aversion has recently decreased and corporate and emerging bond markets are less attractive in term of valuations after their rally. For the time being, the only cheap asset on a relative basis is the stock market. In a world of weak inflation, fixed-income yields should remain low and relative valuations would prevail, knowing that there is plenty of cash ready to be invested. Of course, valuations might not be enough to motivate a rebound and there may be the need for a catalyst.
A positive factor is that earning forecasts are now realistic, after a year or so of downward revisions compatible with the economic consensus. As a result, two elements should provide the signal of the come-back on equities. First of all, the global economic outlook is improving and the earning revisions have turned positive in the US. Secondly, there is a mergers and acquisitions bounce-back, paid for a large part in cash, suggesting that valuations are attractive and that some businesses are ready to act.
As regards the equity asset allocation, the biggest overweight position is emerging markets whatever the region (Asia, Eastern Europe or Latin America). Compared with their developed counterparts, those markets benefit from both attractive valuation and higher growth potential. In addition, each area has its own interest (Asia: domestic growth; eastern Europe: European integration and Latin America: normalisation of the economy and lower country risk premium).
The Japanese market, back to a ‘normalised’ valuation, also appears attractive due to the improved outlook for its domestic economy (from very low expectations) and increasing corporate profitability. Some surveys indicate that the institutional investors are still underweight on the Japanese stocks and we suspect there could some catch-up effects.
We slightly underweight the US and a little more European stocks compared to the other markets. Although, second quarter results on both side of the Atlantic appears to be good (and earning revisions are positive ones). However, we have reduced the underweight position on Euroland.
From a sectoral point of view, we clearly favour cyclicals. We are overweight in materials, industrials, consumer discretionary and more slightly in the financial and technology. This position is based on earnings momentum as well as valuation. Inside the defensives sectors, we like Healthcare which appears cheap but strongly underweight staples and utilities as well as energy.
With regard to the bond asset allocation, we underweight fixed-income government bonds and overweight the credit investment grade, the high yield, the emerging markets and the inflation linked. The recent correction of the government bond markets has erased the overvaluation in the US and in Europe. CLAM does not believe that long term rates will rise above the level implied by forwards, as long as the Fed and the ECB maintain their statu-quo stance. Due to the persistent risks of deflation in the US and Germany, we do not forecast any rate hike for the coming quarters in the G6 countries. Thus, we maintain a neutral duration stance in our portfolios.
European corporate bonds fundamentals are improving: the economy should recover and indebtedness is decreasing. In terms of rating, even if there are still more downgrades than upgrades, the trend is becoming less negative. However, the corporate bond market rally has dramatically reduced the attractiveness of this asset class and we are decreasing the overexposure.
Inflation break-evens have widened recently and inflation linked bonds do not look so attractive, particularly if inflation has to slow before accelerating, because, as many economists say, inflation is lagging the economic cycle. However, there is a case, even if it is not our central scenario, for an inflation linked excess return versus fixed income bonds. Indeed, there are no doubts that the Fed policy is very accommodative. If the US recovery comes out at the top end of the Fed forecasts, the loose monetary policy could feed inflation expectations because the Fed would be behind the curve. As a result, inflation linked bonds currently offer here an interesting asymmetry. Consequently, they might underperform government bonds in our central scenario, but only slightly. However, they could outperform and possibly strongly so, in the case of the adverse scenario.
Benjamin Melman is chief strategist at Crédit Lyonnais Asset Management in Paris