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Asset allocation – No surprise!

Daniel Morris

In this article:

    Tighter US monetary policy, rising (real) yields and a correction in growth stocks. None of this is really a surprise. Markets have been reckoning with such developments for months. The key question was when, and how quickly, would it happen? The answer is now. And quickly.  

    The various market segments have reacted more or less as expected: US equities and fixed income underperformed the rest of the world; (US) growth stocks lagged value; (US) inflation-linked bonds did not keep up with government bonds (see Exhibit 1).

    Exhibit 1: Returns for selected asset classes (in %; year-to-date )

    Data as at 1 February 2022. Sources: FactSet, Bloomberg, BNP Paribas Asset Management.

    For all these moves, there is still the sense that there is more to come.

    The US 10-year real yield has risen by more than 70bp from last November, but at around -50bp, the current yield is still well below pre-pandemic levels (the average in 2019 was +40bp). It is also still below levels seen when secular stagnation was the ‘new normal’.  

    The forward price-earnings (P/E) ratio for the S&P 500 index has now dropped back to 20x – that is about 13% below its peak in 2021 and not far off the levels seen at the end of 2019.

    Exhibit 2: As asset purchases by the US Federal Reserve are tapered, real yields are set to rise and stock multiples could come off their peaks

    Data as at 1 February 2022. Sources: FactSet, Bloomberg, BNP Paribas Asset Management.

    3 factors determining how markets fare from here

    1) By how much the US Federal Reserve raises interest rates this year — by between 75bp as in its latest ‘dot plot’ to perhaps 175bp if it raises rates at each of the seven policy-setting meetings this year. Alternatively, policy rates could rise by less than 75bp if the Fed is forced to pause the tightening cycle due to either a significant fall in equity markets or a slowdown in growth

    2) The expected terminal rate at the end of the tightening cycle – the ‘dot plot’ forecasts 2.50%, while the market has priced in 1.75%

    3) How quickly the Fed’s QE-bloated USD 9 trillion balance sheet is run down.

    We expect five to six rate rises, putting the terminal rate closer to the Fed’s own forecast (and above market expectations). We see balance sheet run-off beginning in the summer at a rate of USD 2 trillion per year.

    Overweight risk assets, underweight duration

    This comparatively modest pace of tightening, in an environment of slowing inflation, above-trend (albeit decelerating) global economic growth and the eventual transformation of the Covid-19 pandemic into an endemic, argues for a continued overweight allocation to risk assets and an underweight in duration.

    We reduced our previous underweight in US large-cap equities after the market falls in January and are currently neutral. We nevertheless expect US stocks to continue to underperform the rest of the world. Monetary policy divergence is one reason. Our research team remains more dovish than the consensus on any monetary policy moves by the ECB, while the People’s Bank of China looks set to pursue broader policy easing. At the same, the Fed is tightening policy.

    Comparatively high valuations are another factor. US earnings growth expectations are modestly higher than those for Europe and emerging markets. That might support US index performance. However, US stocks are trading at a larger valuation premium, which we believe is unwarranted.

    We remain overweight commodities as looser Omicron restrictions allow for the global economy to  reopen further, while supply remains constrained.

    How robust are the current earnings forecasts?

    The latest earnings reports in the US have generally been perceived as disappointing given the comments by some major companies highlighting supply chain and margin challenges. As a result, many analysts have lowered their earnings per share estimates for first-quarter 2022 earnings, although forecasts for the full year have been raised.

    Nearly two-thirds of the S&P 500 companies have reported earnings so far and absolute results have actually been quite good. Earnings have risen by 26% from the same quarter a year ago. This does not appear to be good enough for some market participants, however, especially given the current levels of many market multiples.

    Perhaps it is more relevant to look at how earnings surprises and guidance have fared. Both metrics are near their long-run averages, even if they are now somewhat lower than the unusually strong numbers of 2021.

    Japanese equities and the yen to rally in tandem

    Our overweight allocation to Japan is arguably contrarian. Historically, the outperformance of Japanese stocks relative to the rest of the world has corresponded to a weakening currency.

    From October 2012 to July 2015, equities significantly outpaced the rest of the world, but the weakness of the yen meant that the return in US dollars was close to zero. By contrast, the pattern from December 1998 to January 2000 was the opposite: the rally in Japanese equities coincided with a rally in the currency, boosting returns in US dollar terms.

    We expect to see the latter this year. The outlook for the equity market is positive given robust corporate credit metrics (valuable in a rising rate environment), good earnings momentum, a pro-cyclical market, and low valuations (even by Japanese standards).

    At the same time, the yen looks inexpensive in real, trade-weighted exchange rate terms; many investors are already short the currency (meaning that if the yen strengthens, the rally could be quite strong); foreign investors looking for above average equity market returns are expected to return; and we see scope for the Bank of Japan to step back from its reflation objective.

    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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