Luca Paolini
The Fed’s decision to raise interest rates for the first time in almost a decade does not in itself bring the curtain down on an era of ultra-loose monetary policy. Nor should it prevent stocks from moving higher over the coming months.
The US central bank’s insistence that it will tighten the monetary reins gently and the growing prospect of additional stimulus elsewhere have encouraged us to raise our exposure to equities. Our move is also a response to a recent fall in stock valuations and what we believe is an excessive decline in market expectations for corporate profit growth next year. Our forecast is for another quarter of earnings declines in US before a recovery. However, higher interest rates and slowing economic momentum will make conditions more challenging for US companies to outperform their peers elsewhere in the developed world.
We continue to like the euro zone and Japan, where stocks are relatively inexpensive and exceptionally supportive monetary policies are set to continue. Like their European peers, Japanese companies have seen their global competitiveness boosted by a currency effect – an advantage which is set to endure as the BoJ pursues its massive quantitative easing programme to achieve its inflation target.
In the euro zone, a combination of accommodative monetary policy and economic resilience are creating the backdrop for profits to recover, with the weak euro and low oil price acting as strong tailwinds boosting exports and household spending power. Valuations for European stocks are also the most attractive among developed markets, both compared to bonds and on the basis of normalised corporate earnings. What is more, euro zone equities are trading at their lowest ever level relative to their US peers in US dollar terms.
In our regional allocation, we raise emerging market equities to overweight as valuations for the asset class have become very attractive and we see signs of stabilisation of economic conditions across the developing world. Economic momentum is improving in China and there are signs that this economic strength is filtering through to other parts of emerging Asia. This improving outlook for growth comes at a time when both valuations for – and investor positioning in – emerging equities reflect an excessive level of pessimism. With the pace of corporate earnings forecast cuts having slowed in recent months, we believe the stage is set for an end to the four-year decline in company profits. And with expectations for profit growth now at their lowest levels in years, emerging market stocks have the potential to surprise.
Following a weak period for emerging market bonds and currencies, we feel that these markets will soon come to appreciate the fact that monetary tightening in the US will be gradual and modest. What is more, with economic conditions in the emerging world beginning to improve, we believe the US dollar’s appreciation is likely to slow in the coming months, easing the strain on emerging market fixed income and currencies. With this in mind, we have increased our exposure to local currency emerging market bonds.
Elsewhere, we shift overweight the euro versus the US dollar. Not only do we believe the single currency region’s improving economic prospects could serve as a magnet for investment flows, but we also feel that the scope for a further gain in the US dollar is limited due to its historically high valuation and overly-bullish investor positioning in the US unit.
The author, Luca Paolini, is Chief Strategist at Pictet Asset Management.
