The global macro outlook has improved further and we raise our equity overweight by adding positions in Europe, Japan, and the emerging markets (EM) as well as in US energy infrastructure stocks. In fixed income, we shift from corporate credit to EM debt, and keep a short duration. Lastly, we add a long position in Swedish krona and remain long US dollar, both against the Swiss franc.
Below we present the result of LGT Capital Partners’ latest quarterly tactical asset allocation (TAA) review, which was concluded last Friday. The TAA represents our market assessment for the next three to six months, expressed as our investment positioning relative to our strategic allocation (SAA), i.e. our house view for the coming years.
Our base scenario clearly remains very benign: most indicators point to a synchronous global economic growth pickup and trade is finally expanding again, after several years in retreat. In the US, the purchasing managers’ indices (PMI) are hovering near historic highs, while the labor market is close to full employment. In the Eurozone, the composite PMI readings have risen to multi-year records in Germany and France, and continue to rebound toward past records in Italy and Spain. In Japan, committed policy makers are keeping the economy on its reflationary path, despite occasional setbacks. On the back of this global cyclical and trade rebound, the outlook has also improved in the EM, where even Russia and Brazil are now re-emerging from long recessions. Meanwhile, China’s structural growth slowdown continues to stabilize at a relatively high level, while India has absorbed the one-time shock its radical monetary reform shock last year (so-called demonetization), and returned to its reform-driven growth trajectory.
At the same time, with the United Kingdom’s formal exit process from the European Union having been triggered and elections looming in France and Germany - and possibly Italy - later this year, political event risks remain elevated. However, these concerns are also likely to keep the European and other central banks reluctant to undertake premature or oversized tightening moves in the near future, despite the improved economic momentum - helping to keep markets in a sweet spot.
Only in our risk scenario we envision stagflation-like conditions taking root, with real economic growth slowing but rising commodity prices, sticky wage pressures, and protectionist measures keeping inflation at high levels. However, that outcome is much less likely to materialize than our base scenario.
Arguably, as macro risks have receded, the main question now is whether investors have discounted too much future growth, making markets more susceptible to sharp reversals if reality fails to meet lofty expectations. While we deem this a distinct possibility, especially as the new US administration’s policy plans have yet to be put into actual law, we believe that, as long as the broader reflationary recovery remains intact globally, any such market corrections are more likely to once again prove rather shallow and temporary.
The bottom line is that the typical mix of conditions that often ushers in the end of a bull market is still largely absent (those conditions are: tight monetary policy in the face of slowing economic growth and exuberant investor sentiment after a period of overinvestment). We therefore modestly increase our overweight in equity beta (i.e. positive stock market sensitivity) as well as our underweight in bond duration (i.e. interest rate sensitivity).
In equities, all major regions are now overweight, although we still prefer the developed markets over the EM. However, we modestly pivot from the US to Europe, Japan, and the EM in broadly equal measure. Unlike the other markets, the US should face some headwinds going forward, as rising interest rates meet comparatively rich market valuations. Within the EM, we prefer Asia - namely India, China, and South Korea - and remain cautious on markets with significant governance issues (e.g. Turkey and South Africa).
In fixed income, we slightly raise our big underweight in sovereign debt, to the benefit of our near-neutral position in inflation-linked bonds. As for corporate credit, the positive cyclical outlook is balanced by upward pressure on base rates and very tight spreads, which results in a neutral overall positioning. The EM segment benefits from the improved cyclical outlook and appealing local currency valuations. We thus slightly reduce Investment Grade (IG) and High Yield (HY) and slightly raise our EM debt quota to a marginal overweight. The IG and HY cuts also contributed to fund the below-mentioned new position in US energy infrastructure stocks.
As a counterbalance to our public equity market exposure, we keep an underweight in listed private equity (LPE), where discounts to net asset value (NAV) have either narrowed to unattractive levels, or turned to premiums in some cases. We also keep our small overweights in real estate investment trusts (REITs) and hedge funds.
The outlook for the commodity markets, meanwhile, has become more interesting as prices have stabilized amid improved cyclical conditions and continuous supply-side responses. However, we prefer to keep our underweight in commodity equities and open a new position in energy infrastructure master limited partnerships (MLPs) instead. Despite a strong rally from last year’s lows, the sector remains attractively valued, offering dividend yields of about 7% per annum. And while US tax reform plans pose a certain risk for this sector, that risk is mitigated by the new US administration’s broader benevolent stance toward the traditional energy sector.
We keep small overweight in the US dollar. The recent retracement of the post US-election rally in the greenback notwithstanding, Washington’s political agenda and the US economic momentum remain USD-positive factors in our view. As a result, the Federal Reserve will be increasing rates at a faster pace than last year, which means that current policy divergence will remain in place, even as the European Central Bank (ECB) has started to prepare markets for the eventual end of its quantitative easing program (“tapering”). Overall, an effective tightening of monetary policy still seems a long way off in Europe.
The possible exception is Sweden, where the economy is experiencing a boost in growth, inflation seems set to hit or exceed its target soon, and the real estate market has run hot while the currency is probably the most undervalued among the majors on a purchasing power parity basis. The Swedish Riksbank, after being one of the most aggressive and proactive banks when there was a need to ease, is thus well-positioned for a meaningful and sustained policy reversal in the near future. We therefore initiate a tactical long in the Swedish krona (SEK).
Both the USD and the SEK long positions are held against an equivalent short position in the Swiss franc (CHF). Previously, that short position was shared with the euro (EUR). However, we believe the prospects for the EUR have actually improved recently. Once the French election risks are put behind us and the ECB starts to be verbally more open to taper, the EUR might well stay stronger for longer. We therefore prefer to fund our long position with the overvalued CHF only.
Note: The next LGT Beacon will be published on 20 April 2017.