We remain overweight global stocks, but have reduced risk this month by cutting exposure to emerging market sovereign debt.
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.
Global equities have been subject to large swings in recent weeks. After a weak finish in December, equities started on a stronger note in January. More constructive news flow on tariff negotiations between the US and China supported equity markets. The US Federal Reserve also signaled greater flexibility regarding interest rate hikes. We keep the overweight in global equities in our global tactical asset allocation.
We have no relative preference across size segments and therefore have a benchmark allocation to large-, mid-, and small-caps. While we still think fundamentals for growth companies are on solid footing, value stocks look more appealing given earnings growth and valuation considerations.
Valuations appear supportive of value over growth. Price-to-earnings multiples for value stocks are at their lowest level relative to growth stocks since 2006. Value has more cyclical exposure and tends to outperform when economic growth is healthy, 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. The risk-reward for these sectors appears favorable.
We have no relative preference across size segments and therefore have a benchmark allocation to large-, mid-, and small-caps. Relative valuations for small- and mid-caps now appear more attractive, but near-term uncertainty over global growth may act as a headwind. Leverage in small- and mid-cap companies is above historical averages versus large-caps. This suggests that smaller-sized segments could be more vulnerable than normal if financial market volatility persists.
Relative valuations for small- and mid-caps now appear more attractive, but near-term uncertainty over global growth may act as a headwind. Small-caps have more domestic exposure and disproportionately benefited from tax reform in 2018. However, this boost has faded and for the first time in five quarters, small-cap earnings growth will lag that of large- and mid-caps, as year-over-year comparisons weigh on results. Small-caps tend to outperform when high yield credit spreads narrow. With high yield credit spreads lower than average (after a volatile period in the last several weeks), the scope for further narrowing appears limited, especially considering that we now believe we are in the late stage of the business cycle. Leverage in small- and mid-cap companies is above historical averages versus large-caps. This suggests that smaller-sized segments could be more vulnerable than normal if financial market volatility persists.
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 in the region has weakened, with purchasing manager indices (PMIs) in December dropping to their lowest level since 2013. Although the slowdown was broad-based across PMI sub-components, we expect data to improve in the coming months instead of retreating further into recession territory. The slowdown in car production, resulting from emission-testing issues over the summer, should reverse. Further support should come from lower oil prices, adding to tailwinds from euro weakness throughout 2018. This should lend some support to euro area equities over the short term, while political risks such as the US-China trade conflict and Brexit could reverse any improvement in sentiment.
We are neutral on UK equities. The UK equity market offers an attractive valuation, trading at about a 15% discount to global equities on 12-month forward P/E. However, uncertainties about the outlook for Brexit and commodities keep us neutral on this market. Earnings may enjoy high-single-digit growth in 2019, but remain dependent on the energy and commodities sectors, which account for 30% of the forecast earnings growth estimate. Risks to the upside may come from the energy sector should the oil price rise. This year the spread of earnings growth across sectors is more balanced than in 2018, leading to a potentially less volatile earnings outlook. However, sterling may pose a downside risk should it continue to strengthen. Clearly, the direction of the currency is closely linked to the Brexit outcome. We believe intra-market moves are likely to be greater than headline index moves as a result of Brexit.
We are neutral on Japanese equities. Worries about slower global growth and US-China trade friction led to weakness in 4Q18. Japanese equities were the worst performers in developed markets in 4Q. International investors were the main sellers in 2018. While we have lowered our corporate earnings growth forecasts for the next two years to -2% for each year, we believe foreseeable negative catalysts have mostly been priced in. With supportive valuations well below historical averages, we think some of Japan's quality companies are attractive.
Following a strong start to the year for emerging market (EM) equities, we believe the rally could continue to be driven by further US dollar weakness relative to Asian currencies and more positive developments in the US-China trade standoff. We see further room for EM to perform, especially relative to Swiss equities given the valuation and earnings momentum differential. We see the valuation, at 12x the 12-month-trailing P/E, and earnings momentum of EM equities as more attractive than their developed market counterparts (15x P/E with a more muted earnings growth outlook). The December PMI print was disappointing, but we expect EM growth to stabilize following further fiscal and monetary easing in China. We remain positive on China and Korea and take profit on our long Indonesia position. We remain negative on Taiwan and Malaysia and turn neutral on the Philippines. We stay neutral on Latin America and EMEA due to earnings and political risks.
The market has remained in a fairly tight range since hitting its lowest of 2.55% the first week of January. Since 7 January, the 10-year Treasury yield has remained in a tight range between 2.7% and 2.8% as equity and credit markets seek to recoup their December losses. With the bond market barely pricing in one Fed fund rate hike in 2019, the shape of the curve (as measured by the 2y-10y spread) has begun to steepen. UBS now projects the next rate hike in September 2019. Without full economic data due to the government shutdown, we await our next data signal.
The Fed has signaled its intention to pause rate hikes. We think they will hold rates steady at their March meeting, but believe stronger growth in the second half of the year means the central bank may hike once or twice more this year. We expect somewhat higher rates across the curve and a continuation of the curve flattening trend as the cycle progresses.
In the first few weeks of 2019, tax-exempt paper is exhibiting a firm tone. Month-to-date through 22 January, munis are up 0.4%, outperforming the weaker results posted by US Treasury securities (–0.1%). Net supply is negative, representing an important tailwind for the market. In January, estimated redemptions total USD 28bn. At the same time, we expect monthly new issuance to remain below that level. The steeper curve in munis 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.
Corporate bond spreads widened sharply during 4Q18 driven mainly by falling US Treasury yields on the back of global growth concerns. So far in 2019, the market direction has reversed, with spreads tightening from their three-year peak. We expect further moderate spread tightening and rising Treasury yields. Total returns of US IG bonds have been positive over the past month, supported by falling US Treasury yields. The asset class ended 2018 with a negative return of – 2.25% as carry was counterbalanced by a 60bps rise in spreads. Corporate leverage levels are elevated but have been kept in check by good earnings growth in recent quarters, and the current growth backdrop is strong enough to keep credit quality stable to slightly up (based on aggregate credit rating changes). For now we don't see excessive credit risks, but a strong economic deceleration is a risk that would particularly hit the large BBB rated segment.
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.
Over the past month, interest rates across developed markets moved mostly lower on softer economic data. Italian bonds benefitted from reduced concern over the government’s budget. On foreign exchange markets, the dollar was mixed, gaining against the yen but losing ground against the pound. The net result was a modestly positive return 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 markets (EM) credit delivered low single-digit gains on tighter spreads despite volatile US Treasury rates. The asset class benefited from a more dovish Fed, progress in US-China trade talks, additional Chinese stimulus, and lighter investor positioning. Our six-month base case calls for sideways moves in EM sovereign spreads and slightly wider EM corporate spreads, with low single-digit total returns for the former and close to flat for the latter. Key risks include a sharper-than-expected global slowdown, tighter USD liquidity, and renewed tensions between the US and China.
EMBIGD spreads have tightened 45bps year-to-date to 370bps, on the back of signs of a more dovish Fed and progress on US-China trade talks. We take this opportunity to trim, while remaining overweight the position, reducing our underweight to US government bonds and slightly reducing portfolio risk.