Global Asset Tracker: Asia and emerging markets predicted to enjoy strong year

Among the participants in PWM’s third annual Global Asset Allocator survey, there is almost unanimous consensus that equities will outperform bonds this year, with emerging market stocks expected to generate better performance than equities in developed markets (see Fig 1).

Last year, Japanese equities were the best performers in developed markets, rising 18 per cent, despite a strengthening yen, and most private banks continue to place bets on this market (see Fig 2).

“In Japan, the macro environment is supportive, with GDP growth well above potential, valuations are cheap across the board and corporate fundamentals are improving,” states Alan Mudie, global head of investment strategy at Société Générale Private Banking. 

“Momentum and technicals are strong, while sentiment is still sceptical, which is a plus from a contrarian perspective.”

Emerging markets

Asia ex-Japan equities, and emerging markets stocks, continue to feature as high conviction calls in private banking clients’ portfolios. Their impressive run in 2017 was set against a backdrop of better economic data, less pronounced dollar strength, stronger local currencies and more robust commodity prices. 

These factors, coupled with EM earnings growth and improving profitability, have helped to restore confidence. 

Also, despite the rally, EM equities are rising from a low base, benefiting from a heavy valuation discount to developed markets. 

Within the EM equity space, Citi Private Bank favours Asian equities. “We like structural reforms in several countries, especially the larger economies like India and China, where earnings growth is robust and domestic demand is strong,” says Jeffrey Sachs, investment strategist at the bank.

The MSCI weighting for mainland China will gradually increase, encouraging inflows into mainland Chinese equity, despite rising private sector debt, yet to unsettle strategists.

“China is definitely a risk factor, but if you had bet against China at any stage over the last 10 years, you would have lost,” says Michael O’Sullivan, CIO, International Wealth Management at Credit Suisse.

Policymakers, well aware of risk, use several tools to avoid recession, he says. For China, this would prove not just an economic dip but a disruption of the country’s socio-political stability. 

“Moreover, Chinese policy makers have the benefit and virtue of having great power, more than Western counterparts,” adds Mr O’Sullivan. 

However, in any sell off, emerging markets may suffer more, as lack of liquidity is “a handicap in a risk-off phase,” says Didier Duret, CIO at ABN Amro Private Banking. “On the turnaround, liquid equities will outperform on the upside in the first place, followed by less liquid stocks including EM.”

A quarter of respondents view sector stocks positively, with 50 per cent favouring financials. IT and tech stocks, industrials, cyclicals, and consumer staples are also well regarded. 

“With QE tightening, economic growth and potential inflation, consumption will pick up and companies will profit, but not all of them,” warns Markus Mueller, global head, chief investment office at Deutsche Bank. 

Return dispersion between stock sectors is growing. In the US, tech stocks rose 39 per cent last year, while telecommunication stocks fell 1 per cent, with a 40 per cent dispersion, the highest since 2009. 

“We remain big fans of tech, and think earnings of tech companies will continue to be stronger than expected.” Cyclical stocks, including financials, consumer discretionary and industrials might also profit from the cycle, he says. 

Deutsche’s overweight of Asia over LatAm is related to considerable change in composition of Asian economies, now strongly biased to tech, as opposed to commodity-oriented firms of the past.

The weight of infotech companies in the MSCI Asia ex Japan index has shot up to 39 per cent from 17 per cent in 2007, while that of commodity related companies has decreased to 10 per cent, from 20 per cent 10 years ago. 

European integration

European stocks (ex-UK) remain a high conviction call, well supported by rising growth, fuelled by exports, internal demand, profits and accommodative monetary policy.

“European equities are less expensive than US equities, in particular large multinationals in Europe, trading at excessive discount compared to US counterparts,” says Manuela D’Onofrio, head of investments and products at Cordusio Wealth Management, part of UniCredit Group. 

The Italian bank, overweight on equities, “significantly” reduced exposure to US stocks in March 2017, favouring European and global emerging market equities.

In Europe, there is an underlying theme underestimated by market participants, she points out, which is the desire from France and Germany to open a new phase in the history of the eurozone, leading to deeper integration. This in turn will drive higher economic growth. 

The newly-formed coalition government in Germany and the country’s budget surplus are expected to favour Chancellor Merkel’s drive towards deeper integration, at the same time allowing her government more flexibility with other EU members, on fiscal policy. 

Fading political risk is also a bonus, explains Ms D’Onofrio, although investors see upcoming Italian elections as potential risk for the eurozone, with the populist Five Star movement soaring in polls.

“The scenario that most worries markets is a Five Star movement government, but this is a low probability case,” says Ms D’Onofrio, with a coalition government more likely, with little room to change commitments already made to the European Union regarding structural reforms and reducing the country’s fiscal deficit and public debt.

The tortuous process, which will likely lead the UK to leave the European Union, has been dismissed by survey participants as one of the least important risks to financial markets. It is a problem for the UK, rather than for European markets, which will continue to perform well, states Ms D’Onofrio. 

UK equities are the least popular asset class this year (see Fig 3).

“UK economic prospects are underwhelming due to Brexit uncertainty, while a weak and vulnerable government could face the challenge of early elections, throwing another spanner in the works,” believes David Storm, head of multi-asset portfolio strategy at RBC Wealth Management in London, explaining an overweight stance to Europe ex-UK and an underweight UK position. 

“This contrasts with Europe, where all countries are now enjoying growth, led by stronger domestic demand and signs that business investment is also making a comeback. Relative to US equities, we see greater room for outperformance,” he says.  

Tactical approach

High valuations in the US have driven the sample, biased towards Europe-headquartered global and regional banks, to enter 2018 with a modest tactical US underweight.

But they are not the only factor. “It is all a matter of time frame. On a short-term basis, like a year, valuation has no impact over relative return,” says David Stubbs, head of client investment strategy EMEA at JP Morgan Private Bank. 

“We believe that over 2018 the US could well be the best performing equity market, because of tax cuts and good exposure to tech, which is a big global theme right now,” he says, adding that techs, financials and industrials are the bank’s key sector picks this year. 

Investors must shift from a buy and hold approach to a more tactical one, as volatility rises, recommends Norman Villamin, CIO at UBP Private Banking. “When we look at the big picture in stocks, the story continues to be a good one for 2018, but investors can’t just do what they did in 2017, which is buy, close your eyes and hold and make 20 per cent.”

Fixed income is the asset class where investors and portfolio managers need to actively manage risks, “because spreads are too tight and rates are too low, and that pendulum is going to start to swing, going forward,” he adds. 

“The idea there is risk in fixed income and not so much risk in equity will be a challenge for investors to acknowledge.” 

But one segment of fixed income that has lost its attractiveness, compared to equity, is high yield, says Mr Villamin. “Like everybody else, over the past few years we were huge fans of high yield, which was less volatile than equities. But now is the time to diversify away from it,” he says. Two years ago, high yield represented 10-12 per cent of client portfolios, down to 2 per cent today. 

This view on high yield is shared by the majority of respondents, who see this segment as one of the least attractive of 30 asset classes. Emerging market (EM) debt, where the cycle is in a much earlier stage and spreads are relatively wide, provide investors with a better opportunity in the high-risk credit space. EM local currency debt is viewed as the most interesting fixed income segment, believed to offer attractive carry compared to hard currency bonds, given favourable outlook for EM currency. 

Others prefer a dollar-denominated strategy. “Potentially higher returns in local-currency debt come with higher currency risk in the event of adverse shocks,” says Chris Haverland, asset allocation strategist at Wells Fargo.

It is challenging to find compelling opportunities in fixed income, says Mr Stubbs at JP Morgan. “Our main advice to clients is to go unconstrained on fixed income, and allow managers discretion to move amongst different asset classes… to produce a better risk-reward trade off.”

Private investors still tend to be underinvested in equities. Forty per cent of private banks expect clients’ equity allocations to increase over the next 12 months (see Fig 4). 

Alternative appeal

More than half believe exposure to alternatives such as hedge funds and private equity exposure will rise in clients’ portfolios, adding diversification, while a quarter predict commodities and real estate will increase. Almost two thirds of respondents expect fixed income exposure to decrease.

 “The areas where most clients are under allocated is private equity and hedge funds,” says Katie Nixon, Northern Trust Wealth Management CIO. “We are constructive on both asset classes, so it is likely we will see increases in these two areas.” 

BNP Paribas Wealth Management launched several private equity funds over the past 12 months and is expanding the team and capacity to source and structure these funds and meet increasing client demand. “We see a very strong demand in private equity from our clients in Asia, Europe and the Middle East,” says Vincent Lecomte, co-CEO at the French bank, explaining clients’ commitment to private equity has more than doubled over four years.

“Our highest conviction is on allocating more capital to alternatives, where we still find assets with compelling risk-adjusted returns and relatively low correlation,” says Enio Shinohara, head of portfolio solutions at BTG Pactual.

Within alternatives, the bank’s approach is thematic. “We first identify a specific investment theme and subsequently source and research the best managers and vehicles to participate in that deal,” he says.