We maintain our modest overweight to global equities. We also continue to hold certain overweight positions within fixed income, including an overweight position to 10-year US Treasuries and an overweight to emerging market dollar-denominated sovereign bonds.
Additional asset class information
October brought back volatility in equity markets due to a setback across regions. We see the economic backdrop as still robust. Corporate earnings are advancing globally. But the one-time boost from US tax reform and fiscal stimulus is waning. Thus, earnings growth rates most likely will start decelerating. We keep a small overweight in global equities.
We have no relative preference across size segments and therefore have a benchmark allocation to large-, mid-, and small-caps. However, we are underweight growth versus value. Growth's impressive gains in 2017 have continued into 2018, driven by strong gains in secular growth companies in tech and related sectors (such as e-commerce). While we still think fundamentals for growth companies are on solid footing, value stocks look more appealing given earnings growth and valuation considerations.
We have no relative preference across size segments and therefore have a benchmark allocation to large-, mid-, and small-caps. However, we are overweight value versus growth. Valuations appear supportive for value over growth. Price-to-earnings multiples for value stocks are at their lowest level relative to growth stocks since 2002. Value has more cyclical exposure and tends to outperform when economic growth is solid and/or accelerating, an environment we expect over the next several quarters.
We have no relative preference across size segments and therefore have a benchmark allocation to large-, mid-, and small-caps.
We have no relative preference across size segments and therefore have a benchmark allocation to large-, mid-, and small-caps. Small-caps have more domestic exposure and are disproportionately benefiting from tax reform this year. However, small-caps' earnings growth advantage should shrink as the market starts to focus on the outlook for 2019. small-caps tend to outperform when high yield credit spreads narrow. Both small-caps and high yield are riskier segments within equities and fixed income. With high yield credit spreads already low, the scope for further narrowing appears limited. Leverage in small- and mid-cap companies is above historical averages versus large-caps.
We are overweight Canadian equities. Companies are showing healthy earnings growth, which is generally expected to come in slightly above 10% this year. Banks, which make up close to 30% of the market, are likely to benefit from further Fed rate hikes.
We are neutral on Eurozone equities. The latest economic indicators confirm that the broad-based expansion is ongoing. The weakening of the euro relative to the US dollar in recent months should help profits of export-oriented companies. Still, uncertainties about trade tariffs and demand from emerging markets remain major risks for EMU equities.
We are neutral on UK equities. They are among the cheapest equity markets in our coverage universe. Earnings growth is robust, in the upper-single-digit range. Still, Brexit negotiations will increasingly move into focus.
We are neutral on Japanese stocks. While earnings growth is relatively strong, we forecast that it will slow going forward. Still, the market is attractively valued.
We are neutral on emerging market stocks. The environment remains challenging with the risk of further import tariffs by the US on Chinese goods being announced. After the recent setback, valuations got more attractive. The region is trading at close to a 30% discount to developed market equities based on trailing P/E.
We remain underweight US government bonds. Interest rates rose over the past few weeks on the back of rising real rates, rising oil prices, and a hawkish Fed. Yields on the 10- year Treasury moved to a year-to-date high of 3.25%. We believe this peak in yield should hold unless fundamentals shift to the hawkish side via the European Central Bank (ECB) or the Bank of Japan (BoJ).
We think the 10-year US Treasury yield has largely priced in the hiking cycle. We thus overweight 10-year Treasuries versus USD cash, a position that should benefit from positive carry and roll-down.
In early October, munis exhibited weakness based on a sudden spike in US Treasury yields. Month-to-date, tax-exempt paper (-0.7%) underperformed Treasuries (-0.5%) based in part to outflows from muni mutual funds. The withdrawals were a reversal after four straight months of net cash inflows. In the near term, we expect outflows to continue until rate volatility in taxables subsides. We continue to favor investment grade munis vs. lower rated tax-exempt bonds based on tight credit spreads.
Rising Treasury yields and wider credit spreads have resulted in a year-to-date total return of -3.1%. Investment-grade (IG) spreads widened by only 3bps during the recent market volatility since spreads had already adjusted higher throughout this year. IG spreads currently stand at 116bps, which is toward the low end of our target range of 110-125bps, and we expect sideways moves into year end. Within IG, we continue to favor financials (US banks) over non-financials due to their strong credit profiles and shorter duration. In addition, IG corporates with short maturities (1-3 years) provide attractive yield of 3.3% relative to their short duration of only 1.9 years.
After reaching a new post-crisis low of 316 basis points (bps) in early October, high-yield (HY) credit spreads widened back to 345bps. Rising Treasury yields hurt total returns too, leaving them down 1% from their peak and +1.8% for the year. Although HY spreads fall below our target range, a decline in issuance, benign fundamentals, and low default rates should continue to support the HY asset class and we maintain a neutral position. The trailing 12-month default rate was 1.1% in September, well below the long-term average of 4%. We expect the default rate to remain broadly steady over the next 12 months. We continue to favor senior loans that should benefit as coupon income increases due to rising LIBOR levels.
Over the past month, interest rates across developed markets were mixed, with modest declines in some countries but a big move higher in Italian yields. On foreign exchange markets, the dollar was also mixed, gaining against the euro but losing ground against some other currencies. The net result was slightly negative returns over the month. Non-US developed bond yields remain mostly at very unattractive levels. We do not recommend a strategic asset allocation position on the asset class.
Emerging market (EM) credit has been hurt by USD strength, higher Treasury yields, rising concerns about external vulnerabilities in select countries, and trade tensions. Year-to-date, the asset class posted low-to-mid negative single-digit returns as spreads widened. Our base case calls for slightly tighter EM sovereign spreads over the next six months and sideways moves in EM corporate credit spreads amid greater volatility. A full-blown trade war remains a key risk, although aggregate EM fundamentals look relatively strong. We advise investors to be overweight in EM sovereign credit and neutral in EM corporate credit in globally diversified portfolios.
Emerging market sovereign credit has been hurt this year by broad USD strength, higher US Treasury rates, rising concerns about external vulnerabilities in select countries, and global trade tensions. The asset class has posted a 4% loss year-to-date as spreads widened. Our base case calls for slightly tighter EM credit spreads in the next six months in an environment of high volatility. EM fundamentals on aggregate look relatively strong currently and the carry is attractive, while a further escalation in trade tensions remains a risk. We maintain our overweight on EM sovereign bonds in USD relative to high grade bonds in globally diversified portfolios.
Tactical recommendation to hold more of the asset class than specified in the moderate risk strategic asset allocation.
Tactical recommendation to hold less of the asset class than specified in the moderate risk strategic asset allocation.
Tactical recommendation to hold the asset class in line with its weight in the moderate risk strategic asset allocation.
* We do not apply tactical preferences to non-traditional asset classes. Additionally, non-traditional assets are not be suitable for all investors.
Note: This is a visual summary representation of our positioning. Please visit the full monthly report for our full detailed asset allocation tables.