Markets have bounced back strongly from the February lows and investor flows and positioning now suggest some complacency. Given the increased event risk in coming months, we see scope for profit taking and short term volatility. We make some tweaks to our positioning and consider applying short term hedges to bridge the summer month period. However, our longer term constructive stance on global equities and emerging market assets has not changed.
- Increased event risk is unlikely to be a fundamental game-changer. European events (UK, Spain, Greece) and global central bank meetings can create volatility in the short term. However, global growth and policy remain supportive for riskier assets in the longer term.
- To position for potential summer volatility, we make small allocation changes and consider hedging strategies.
- European event risks lead us to tactically downgrade the Italian stock market and European peripheral bonds to a neutral view.
- Markets are increasingly sceptical about policy effectiveness in Japan, and we downgrade its stock market to a small underweight.
- We maintain our overweight of emerging market bonds and equities. EM assets continue to be supported by improving data, their yield, a soft USD and a positive long term backdrop.
- Although overweight on equities and emerging market assets, our positioning is defensive. We focus on assets with positive fundamentals, liquidity and diversification.
Long term positive, short term cautious
We maintain our longer term positive outlook on select high quality riskier assets, including global equities, credit and emerging market assets. This view is based on global economic data, which remains constructive, and on the comfort that any weakness in data will lead developed market central banks to add to monetary easing (Eurozone and Japan) or delay tightening (US and UK). We also believe that the end of the USD bull run and the bottoming of commodity prices are good for risk appetite in the medium term.
However, in the short term, there are a number of obstacles related to performance, positioning and event risk.
1. Performance: too far, too fast?
Markets may run into some resistance simply because of strong recent performance. Equity, credit, currency and commodity markets have bounced sharply from their February lows, and US equity markets are trading close to historical highs.
The sharp fall in USD and the bounce of the oil price have been very positive for risk appetite. If these factors stall, many other assets may run out of steam as well.
2. Positioning is not supportive
There are a number of ways to measure the mood of the market and current positioning. It is interesting to look at the size of speculators’ positions (see below) on futures and options exchanges. Currently, they do not see much risk of interest rate hikes (they hold big Treasury positions) and they believe there is little risk that volatility will pick up (low VIX positions). Such extreme speculative bets can be contrarian indicators, and when markets start to move against them, the size of the correction can be exacerbated.
To us, this positioning suggests that short dated volatility is ‘cheap’ at this point and can be used to hedge stock portfolios. The Treasury position suggests that the recent Treasury rally may run out of steam and yields could bounce slightly from here. This may temporarily slow credit spread compression in developed markets and hard currency EM markets.
3. Event risk
There are a number of events on the horizon. They include the next Bank of Japan meeting (15-16 June), the UK referendum on European Union membership (23 June), the Spanish elections (26 June), a EUR 2.3bn payment due by Greece (20 July) and the Federal Reserve meetings (15 June and 21 September).
In the case of the European events, the fears are mostly related to the continued coherence of the Union. Any indications to the contrary could lead to widening of peripheral spreads and underperformance of peripheral assets, in our view. We worry that markets will not give Europe the benefit of the doubt, and hence, we tactically downgrade the Italian stock market and peripheral bonds to neutral.
For Japan, expectations are high that the Bank of Japan will buy shares or ETFs in the market, but we think that there are risks around this scenario, and believe that weak economic data, slow reform, a downtrend in earnings momentum and recent JPY strength should all weigh on performance. As a result, we downgrade the Japanese stock market to a small underweight.
We do not like to invest based on seasonality and mantra such as ‘sell in May and go away’. However, when event risks increase, and market have had a significant bull run, we believe there is a good risk of profit taking and some short term volatility.
Staying the course: two ‘positive’ trades
While most of our changes this month express short term caution, we upgrade two assets that reflect our continued longer term constructive outlook on global growth, the commodity cycle and emerging markets. We upgrade Canadian stocks to neutral from a small underweight. This upgrade is based on our positive view on the broad commodity spectrum. We also upgrade emerging market currencies to neutral (short term) and neutral with a positive bias (longer term). Following the bounce, we may have short term consolidation for some EM currencies, but we believe that continued improvement in fundamentals, USD weakness and commodity price uptick should lead to support for EM currencies in the medium term.
In summary, we believe that our current positioning is defensive enough to ride out the short term volatility with a small overweight in equities and emerging market assets. We consider hedging exposure and have cut investments that would be most impacted by the event risk, if it escalated. We continue to have a selective approach in emerging markets and credit, and focus on liquidity and diversification.
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.
