While developed market economies are seeing increased headwinds, emerging market growth seems more resilient. Following our earlier decisions to upgrade EM debt and FX, we now upgrade EM equities to a small overweight. Following the recent bounce, we bring down our allocation to Europe ex-UK as we believe that weak growth and rising event risk may be obstacles for equity performance in the region in the near term.
- Our economists have downgraded economic growth in developed markets, while keeping emerging market (EM) growth little changed. Russia and Brazil are expected to come out of recession before 2017, and Chinese data is starting to see the impact of stimulus measures.
- Emerging market sentiment is also boosted by financial market developments. A slightly weaker USD, lower risk of rapid rate hikes in the U.S., increased clarity on Chinese FX policy and an improving outlook for oil prices are all supporting flows into EM.
- We therefore increase our allocation to emerging market equities to overweight. We have upgraded China, Philippines, Malaysia, Russia, Turkey and Brazil. We are more cautious on Taiwan.
- Europe on the other hand is seeing significant headwinds. The slow recovery is further challenged by a rising EUR, higher oil prices and the rising event risks in coming months.
- We maintain our small overweight position in equities and hedge funds, with an underweight in bonds and cash. The geographical changes in our equity allocation express a slightly more optimistic outlook for markets.
Maintaining our constructive global outlook
Our economists have downgraded global GDP growth from 2.5 percent to 2.3 percent this year, driven by the downgrade of developed markets (from 1.9 percent to 1.6 percent). Emerging markets growth is downgraded less (from 3.9 percent to 3.8 percent) and is expected to pick up further to 4.5 percent next year. By comparison, developed market growth should remain lackluster next year, at 1.8 percent.
It is not surprising, therefore, that sentiment towards emerging markets has started to improve, and that investment flows are being redirected towards EM. We want to follow this trend.
In our view, some further developments should help global risk appetite, causing us to maintain our overweight position in equities and credit:
- First, central bank policy remains very accommodative, with the ECB about to start its corporate bond purchases, and with the Federal Reserve being very aware of the global consequences of any interest rate hikes.
- Second, sentiment is not overstretched. Analysts have remained relatively cautious on most markets, allowing earnings growth to continue to exceed expectations, and even leading to earnings upgrades in recent weeks (the exception being Japan).
- Third, we think that global risk appetite should be boosted by slower U.S. rate hikes, a more stable USD and oil prices, a stabilization of Chinese growth and additional clarity on Chinese policy.
The promise of higher oil prices should also help. Oil had weighed significantly on risk appetite in 2015, as lower oil prices created government and current account deficits for a number of countries (especially EM); it led to spread-widening in high yield (hurting credit market sentiment more broadly), and it contributed to deflation risks and negative interest rates. While it may take time for some of these effects to be reversed, a stabilization of oil prices should contribute to lower risk premiums in emerging markets and credit.
Downgrading Europe ex-UK to neutral
European stocks are likely to see some increased headwinds or risks, and we therefore reduce our position in Europe ex-UK. Although some indicators lately have been better than expected, there remains skepticism about the ability of the ECB to rapidly boost activity through its new bank credit facility (TLTRO, or Targeted Longer-Term Refinancing Operations). The expectation of bond buying has of course boosted corporate bond prices, but underperformance of credit default swaps, stock markets and the European bank sector indicate that markets remain skeptical about any material and quick benefits to the European economy.
In addition, Europe is facing some increased risks. These include the risks related to the immigration crisis, a possible snap election in Spain due to inconclusive coalition talks, the uncertainty ahead of the UK referendum on EU membership and the renewed Greek debt talks.
Finally, higher oil prices in the medium term could remove one of the main areas of support for the European consumer, while a stronger EUR could hurt competitiveness.
Performance of the Europe ex-UK stock market has been mixed. Europe outperformed the U.S. from October 2014 to April 2015, and again from September 2015 to December 2015, but has underperformed since. Higher dividends in Europe helped, but the area still slightly underperformed the U.S. in the past two years. We believe that the 6+ percent bounce of the past two weeks (and 15 percent from recent lows) gives us an opportunity to close the overweight.
Upgrading emerging market equities
In recent months, we have gradually been adding risk in emerging markets (EM), starting with hard currency debt, followed by local currency debt and lately also taking a more positive view on a number of
EM currencies.
We now upgrade emerging market equities, for a number of reasons:
- First, we see a tentative stabilization of economic activity in a number of countries, most notably in China. Trade activity was more positive than expected in recent weeks, and profit growth has come back to positive territory after contracting since late 2014. Economic reform and stimulus seem to be having some impact, in line with our view of stabilizing growth in H2.
- Sentiment should also be helped by a slightly weaker USD. Markets had been worried about China potentially devaluing its currency to gain competitiveness. With EUR and JPY strengthening against USD, CNY automatically weakens against its trading partners, thereby lowering the risk of a devaluation. This could allow other emerging market currencies to strengthen without losing much competitiveness against CNY. In turn, stronger currencies could allow some EM central banks to become more accommodative, helping economic growth.
- Third, EM sentiment is highly correlated to oil and commodity prices. Although there was no agreement in Doha, we believe that oil prices will rise later in the year as a result of falling U.S. production and improving global demand. Oil exporters may be most positively affected, but sentiment towards the asset class generally benefits from higher oil prices.
Although valuations have become more demanding, we think this is in part because earnings expectations have been so weak for very long. For the region as a whole, analysts have been downgrading earnings ever since mid-2012. We think these earnings expectations are now undemanding, giving a scope for further upside.
Market positioning is generally relatively light. We think that this could help performance, as investors who are underweight in EM adjust their positions on a more constructive outlook.
Generally, for EM countries (in contrast with some developed markets), FX and equity markets move in the same direction. Our constructive view on EM currencies is therefore also in line with our view on FX.
In summary, we maintain our small overweight position in equities, but shift our preference from Europe to emerging markets. This makes our portfolio slightly more ‘pro-risk’ in nature. This stance is motivated mainly by the recent ECB measures, a slow Fed and the increased support for oil prices in the medium term.
Jose A. Rasco is the Chief Investment Strategist for HSBC Private Bank-Americas. He is a member of the Global Private Bank Investment Committee. This column is for informational purposes only. It consists of general market commentary and should not be relied upon as investment advice.
