By Pictet AM
The Fed’s rate cut heralds a new period of monetary easing, which promises to revitalize emerging markets in particular. As a result, we are upgrading emerging market equities, excluding China, from neutral to overweight.
These stocks are very cheap, while earnings momentum in several markets appears healthy. Overall, emerging economies are growing faster than developed countries, inflation dynamics are favorable and the US is easing in a non-recessionary environment, which we believe is enough to offset concerns generated by US election risks (see Fig. 3). Our indicators show that earnings momentum is strongest in emerging markets and Japan, based on 12-month earnings per share forecasts and market breadth.
Despite Beijing’s most recent efforts to pull the country out of its economic malaise through a number of fiscal and monetary measures, we prefer the rest of the emerging markets to China. For a start, China’s problems are deep-rooted and require structural change rather than short-term solutions. While domestic equities have reacted strongly to these measures, the sustainability of the rebound will depend on implementation and follow-up by the authorities. In addition, as the US election cycle enters its home stretch, we avoid adding exposure to the assets most directly affected by rising tariffs and trade uncertainty.
Among developed markets, we continue to overweight Japanese equities. Japanese corporate earnings are showing better momentum than in other countries, and market valuations remain attractive. Overall, the market offers a structurally sound investment case, as the economy emerges from deflation and governance changes should encourage further efforts to enhance shareholder value. Any further appreciation of the yen is likely to be moderate, which should limit currency risks for both companies and investors. Next year, the archipelago’s economy is expected to grow by around 1.4%, double its potential.
We maintain exposure to Swiss equities, a market with many companies trading at very attractive valuations and with stable earnings. We also appreciate exposure to the defensive qualities of this market, which serves as a hedge against our central soft-landing scenario.
We are also downgrading communication services from overweight to neutral. Since the start of the year, the sector has outperformed the rest of the market by 23 percentage points, thanks to US technology companies. However, this rebound is now in danger of running out of steam. Corporate earnings are no longer a clear headwind, valuations are neutral at best, and technical factors are now negative. We continue to overweight financial stocks, which should benefit from a steeper yield curve with further Fed rate cuts and hopes of deregulation. Bank earnings are also solid. We remain overweight utilities, which we value for their defensive characteristics, stable earnings and attractive valuations. We remain underweight real estate – although the sector may finally benefit from lower interest rates, it remains expensive and demand for office buildings has yet to rebound.
Bonds and currencies: raising emerging market debt
With rate cuts in the US now a reality, the bond landscape is changing. We expect emerging market bonds to be the main beneficiaries of the Fed’s policy change.
The higher yields on offer in developing countries will become increasingly attractive. Indeed, we have already seen a resumption of flows into this asset class in recent weeks, in the wake of the Fed’s first rate cut. What’s more, rate cuts in the US will enable emerging markets to ease their own monetary policies, further stimulating economies where inflation has slowed and financial stability is not a major concern.
Conditions look particularly favorable for emerging market bonds in local currency, which we are upgrading to Overweight in the expectation of a rise in emerging currencies against the greenback.
Dollar-denominated emerging market corporate bonds should also perform well. Our economists take a positive view of emerging economies, and expect the recovery in global trade to boost corporate activity. Any rise in commodity prices could bring an additional benefit. We therefore upgrade emerging corporate bonds to overweight.
In developed markets, we are underweight Swiss bonds, which we believe are expensive (according to our valuation measures, they have been expensive relative to other government bonds only 30% of the time). Even if the Swiss National Bank reacts to faltering economic momentum by lowering interest rates, its ability to ease monetary policy is limited, given the current low interest rates.
We remain neutral on US Treasuries, whose valuations seem fair given their track record over the past 20 years. Foreign investor demand for US government bonds remains strong, but we would like to have more visibility on the likely outcome of the US elections before deciding to change our position. That said, we still see some value in inflation-indexed Treasuries, or TIPS. These securities could offer useful protection in the event of stronger-than-expected US inflation in the medium term (particularly in the face of rate cuts).
At first glance, developed-market corporate bonds appear to be an attractive asset class in the face of sluggish economic growth and receding inflation. That said, on closer inspection, valuations appear fair to high. We believe that the fall in bond yields can only go so far, and that spreads remain very tight by historical standards (spreads on US investment-grade securities stand at 92 basis points, compared with a 10-year average of 130, for example). Our position on developed-market credit is therefore neutral, for both investment-grade and high-yield segments.
On the currency markets, we are neutral on the dollar against almost all the major developed market currencies. The short-term outlook for the greenback is clouded by the US elections.
The exception is the euro. We are downgrading it to Underweight in view of a clear slowdown in economic momentum in the monetary union (we now forecast growth of just 1.3% next year, compared with 1.5% last month). The ECB has remained aggressive, even though it has cut interest rates. Even so, we believe that the central bank’s tone will soon become more accommodative as inflation continues to slow, triggering further rate cuts that could put downward pressure on the euro.
We maintain our overweight position in gold, which continues to erase new all-time highs despite increasingly stretched valuations and positioning (with net longs at their highest level since 2017). Rate cuts by the Fed – as well as the ECB and the Bank of England – are reducing the opportunity cost of holding a non-yielding asset like gold, and acting as a catalyst for a recovery in financial demand through ETF flows. While the yellow metal looks overbought at the tactical level, we are prepared to use any means to strengthen our strategic allocation.