EquitiesFeb 12 2015

Tactical allocation benefits

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Tactical allocation benefits

Not only is the world economy troubled by a persistently weak eurozone, a recession in Japan and slowing growth in emerging markets, but its prospects are also hostage to worrying political developments, particularly Russia’s worsening relationship with the West. Should a sharp downturn ensue in 2015, riskier asset classes would surely suffer, while government bonds and the US dollar could add to this year’s gains.

In our view, however, the investment climate in 2015 is unlikely to be so harsh. Although the global economy faces a number of obstacles, I believe it can avoid a steep downturn and deliver modest growth. Under a base-case scenario, equities should outperform bonds, with developed markets – particularly Japan – performing well, and some emerging stock markets likely to recover due to their attractive initial valuations. Emerging market debt should also offer interesting investment opportunities, in contrast to developed government bond markets where historically low yields point to meagre returns this year.

Global growth and inflation will remain below the historical norm in 2015. World output is likely to expand at a sub-par pace over the next few years chiefly because public spending cuts will continue to be a feature of government policy worldwide. There is little room to boost demand through fiscal stimulus – public debts have risen, not fallen, since the 2008 financial crisis.

Even so, growth promises to be better this year than it was in 2014. One reason is lower energy prices. As oil prices have fallen to their lowest levels since 2005 on an inflation-adjusted basis, consumer spending is certain to rise, which in turn should lift growth.

Indeed, I estimate that the oil price decline has already added as much as 0.5 percentage points to global growth this year. Lower oil prices should also provide a boost for emerging economies, particularly oil importers, some of whom are taking advantage of lower energy costs to implement reforms such as the elimination of fuel subsidies.

Monetary policy should also help underpin world growth. Although the US Federal Reserve is edging towards interest rate hikes, central banks elsewhere – the Bank of Japan and the ECB in particular – are expected to act more aggressively to stave off the threat of deflation. This should sustain central bank liquidity globally through 2015.

Economists expect global growth to rise to 3.2 per cent from 2.7 per cent in 2014; the US will be the best-performing major economy, registering growth of some 3 per cent; output will edge up by 1.1 per cent in the eurozone and by 1.5 per cent in Japan. Emerging markets will grow at 4.8 per cent, up from 4.4 per cent in 2014. But we believe the picture could improve still further – 2015 might deliver some positive growth surprises.

When it comes to assessing the investment prospects for major asset classes, equities continue to offer better return prospects than bonds. This is chiefly due to relative value – stocks are simply less expensive, and should deliver high single-digit returns in 2015. Even so, as market expectations for growth and interest rates are bound to fluctuate, investors should be prepared for higher volatility.

Our preferred developed world stock market for 2015 is Japan. Japanese stocks are attractive on several fronts. First, the sharp depreciation in the Japanese yen has boosted the competitiveness of corporate Japan versus its global peers. Second, Japanese companies are becoming more shareholder-friendly, raising the prospect of a sustained increase in their return on equity. The third reason is linked to valuations. The Japanese stock market rally has so far been fuelled by a rise in corporate earnings rather than the expansion of earnings multiples seen in other equity markets; this makes the valuation of the Japanese market increasingly attractive.

By contrast, in the US, corporate profits – rather than valuation multiples - need to improve to drive markets higher. With the economy growing steadily, job creation strong, and disposable income rising thanks to falling energy costs, we see the potential for earnings growth in a number of US industry sectors.

The outlook for Europe remains mixed. I believe the investment climate for stocks should steadily improve as the ECB is becoming ever more aggressive in its bid to avert deflation. What is more, the weak euro should improve the competitiveness of the region’s exporters, which in turn could boost corporate earnings. But risks remain – the shifting political climate in Greece (and the UK) is among our key concerns and could prove to be a source of market volatility.

When it comes to industry sectors, I prefer consumer discretionary and technology stocks. Lower fuel costs should translate into higher consumer spending – in the US and elsewhere – boosting earnings among consumer-facing companies. The tech sector’s prospects, meanwhile, should be underpinned by healthy levels of capital expenditure. We remain cautious on energy-related stocks and materials companies for the time being given the ructions in commodity markets.

The outlook for emerging market stocks is improving, but not for every sector or country as the recent fall in the price of oil and other commodities is a mixed blessing for the asset class. Valuations are compelling in some areas, but in many cases there are few fundamental reasons pointing to gains this year. The markets of countries whose competitive positions have improved thanks to weaker currencies and structural reforms are likely to deliver healthy returns. Markets that are home to companies that benefit from falling oil prices (India, Korea, Taiwan) look better positioned than those that are dominated by commodity exporters (Russia, Brazil).

In fixed income, government bonds do not look especially appealing. But with economic growth and inflation likely to be modest and ultra-easy monetary policies of both the ECB and BoJ countering the Fed’s withdrawal of monetary support, we do not expect a dramatic rise in bond yields. Investment grade bonds are also unlikely to see much in the way of selling pressure as investor appetite for yield should persist. The recent sell-off in corporate speculative-grade debt, meanwhile, could throw up investment opportunities as yields are at attractive levels even though investors should be wary of growing financial pressures among issuers in the shale oil sector.

The prospects for emerging market debt are also quite promising. Local currency bonds should benefit from a recovery in emerging currencies, which our model shows are trading some two standard deviations below fair value. Bond valuations are also attractive – the yield differential between emerging market local currency and developed government debt is far above the long-term average. Valuations aside, monetary policy should also provide some support – we believe a growing number of emerging central banks will take advantage of a decline in inflationary pressures to shift to a more dovish stance this year to cement growth. China and India’s recent interest rate cuts are part of this trend.

Overall, I am pretty sanguine about 2015 – there are reasons to be optimistic. But the year also promises market dislocations that present both opportunities and risks for investors. Tactical allocation will be key, as will hedging against a possible rise in market volatility.

Andrew Cole is senior investment manager, multi-asset team of Pictet Asset Management

Key Points

The investment climate in 2015 is unlikely to be so harsh as the political climate.

The preferred developed world stock market for 2015 is Japan.

The outlook for emerging market stocks is improving, but not for every sector or country as the recent fall in the price of oil and other commodities is a mixed blessing.