Earlier this month we increased our overweight to global equities as we believe October's sell-off created a buying opportunity. However, we also continue to hold certain counter-cyclical positions that can help protect portfolios against downside risks. This includes an overweight to US 10-yr Treasuries.
Additional asset class information
Global equities fell about 7% in October, representing one of the worst-performing months for the asset class since the global financial crisis. Still, global leading indicators, especially for the service sector, point to robust economic growth. The US labor market remains robust and US earnings delivered slightly more than 25% year-over-year growth in the third quarter. This will slow in 2019 as the year-over-year lift from corporate tax cuts rolls off, but we continue to expect US earnings growth to be positive at 4%. In Europe, we look for mid-single-digit growth, and in the emerging markets 8%. Against this benign fundamental backdrop, we recently increased our tactical overweight to global equities versus government bonds – a position we had reduced in the summer.
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. Sector considerations are also a key driver of our value overweight. We are overweight energy and financials, which make up one-third of the Russell 1000 Value Index.
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. The market looks attractively valued. With the new trade agreement between the US, Mexico, and Canada, some of the valuation discount should be released.
We are neutral on Eurozone equities. Economic data has been negatively affected by trade tensions and the introduction of new emission standards for autos. At least the latter should prove temporary and lead to some improvement in manufacturing data in the coming months. The recent weakening of the euro relative to the US dollar should also support export-oriented companies. Uncertainties about trade tariffs and demand from emerging markets remain major risks. About 30% of EMU companies' revenues are generated in emerging markets.
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 be in focus with the deadline in March approaching. While in our base case we expect an exit agreement with the EU, the path to it could lead to volatility for UK equities in the coming weeks.
We are neutral on Swiss stocks. They have held up relatively well in the latest sell-off due to their strong tilt to defensive sectors. Their premium to global equities has thus risen to 15% based on trailing P/E.
We are underweight Australian equities. The market has held up relatively well this year. Its valuation does not look attractive, especially relative to Canadian equities. From a structural perspective, regulatory measures are likely to limit banks' earnings growth.
We are neutral on Japanese stocks. While earnings growth is relatively strong, we expect it to slow. Still, the market is attractively valued. The threat of higher tariffs on US automobile imports still lingers. A stronger yen in a risk-off environment also remains a risk.
We stay neutral on emerging market equities. Following the short-lived technical rally seen at the end of October, we continue to see liquidity tightening, the continued US-Sino trade standoff and slower expected global growth as key headwinds for emerging markets (EM) equities. We wait for better macro indicators and a weaker USD to turn more positive. We expect the negative earnings momentum to continue and the consensus earnings growth estimate of 12% for the next 12 months to fall. Valuation is more attractive at close to 11.5x 12-monthtrailing P/E. Relative to developed markets, EM equities are cheap, trading near a 30% discount. We remain positive on China and Korea as trade concerns seem overpriced. We turn neutral on Thailand and positive on Indonesia. We remain negative on Taiwan, the Philippines and Malaysia. We stay neutral on Latin America and EMEA due to earnings and geopolitical risks.
After breaking out of their narrow range last month, driven by strong labor market momentum and the Fed's greater confidence in the economic outlook, rates remain at about the same level as a month ago. Inflation remains near the Fed's target and shows no signs of accelerating alarmingly, but capacity constraints mean the Fed will continue its gradual hiking cycle as long as the economic outlook remains healthy. The Fed is likely to hike once more this year, with further hikes likely next year. We expect the yield curve to continue to flatten.
We believe the US rate cycle has been largely priced in and think the 10-year US Treasury yield is attractive. Duration is also likely to cushion the impact of any fall in risky assets. We are therefore overweight 10-year US Treasuries versus cash.
In the early part of 4Q18, tax-exempt paper exhibited weakness based on a sudden spike in US Treasury yields. Month-to-date through 13 November, munis registered a modest return (+0.1%) taking its cues from a firmer US Treasury bond market. The steeper muni curve versus the one seen in the US Treasury bond market presents an opportunity for muni investors to pick up better value a bit further out on the curve. We expect to witness acceleration in tax-loss harvesting as year-end approaches.
Investment grade (IG) corporate bonds held up relatively well through the recent equity market turmoil. Still, spreads widened over the past month and weighed on returns. Bonds with short to medium maturities outperformed longer-dated ones. Current spreads are at the mid-point of our target range and we expect them to remain range-bound over the next six months. As Treasury yields should stabilize around their current levels, we expect IG total returns slightly below current yield levels of 4% p.a. Corporate leverage levels are elevated but have been kept in check by good earnings growth in recent quarters. Primary market issuance remains healthy, but is trailing last year's record volume by 10%. For more details on corporate leverage, please refer to our recent publication "A look at corporate leverage" (published 5 November).
Volatility in the equity market and the WTI price falling by over USD 10/bbl hurt US high yield bonds since our last publication. Credit spreads widened by around 50bps, leaving total returns down 1.2%. CCC rated bonds, the riskiest cohort, underperformed with credit spreads wider by almost 140bps and total returns down 3.4%. We raise our credit spread forecast to 420–460bps to account for the fading growth impulse of corporate tax reform next year, the gradual tightening of financial conditions, and the more advanced stage of the economic cycle. The 12-month-trailing default rate was stable at 1.1% in October, well below the long-term average of 3.5%. We expect it to move gradually to 2.5% over the next 12 months.
Non-US developed bond yields remain mostly at very unattractive levels. We do not recommend a strategic asset allocation position on the asset class.
EM corporate credit has posted a 2.2% loss this year due to rising US yields and roughly 50bps of spread widening. Broad USD strength, escalating trade tensions, and disappointing macro data in select countries have weighed on the asset class, raising concerns about EM growth prospects and external vulnerabilities. We expect spreads to trend sideways to slightly lower over the next six months and low single-digit returns for the asset class. A full-blown trade war and rising US Treasury yields remain key risks to watch, but this is mitigated by stabilizing-to-improving credit fundamentals, still-robust EM growth, higher energy prices, and, more generally, our view of gradually stabilizing (though volatile) global conditions. We advise investors to remain neutral on EM corporate credit in globally diversified portfolios and to be selective.
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 5.3% 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. The carry of the asset class remains attractive, and the recent improvement in a number of idiosyncratic stories such as Brazil, Argentina, and Turkey is encouraging. A further escalation in trade tensions remains a risk, as well as a more pronounced deterioration in economic fundamentals. We maintain our overweight on EM sovereign bonds in USD relative to government 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.