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Citi

2Q18: Stay Diversified Amidst Higher Volatility

In February, equity markets fell given concerns that an increase in US inflation could drive the Fed to more aggressive rate hikes. Global equity markets rebounded swiftly and were then impacted when the US imposed trade tariffs on steel and aluminum imports on 9 March and then announced potential tariffs of $50B on Chinese imports on 3 April. US Technology stocks also experienced a selloff at March-end over concerns on data protection and increased regulatory oversight.

 

In spite of Q1 2018 stock market volatility, global economic fundamentals remain strong. Citi analysts expect the global economy to grow 3.4% in 2018 up from 3.3% in 2017, with global inflation expected to rise slowly to 2.5% in 2018 from 2.4% in 2017. Citi analysts forecast positive global equity returns in 2018 with earnings-per-share (EPS) up 13%.

 

Risks to global trade remain elevated given that a rise in US protectionism may elicit retaliation by its trading partners. However, Citi's base case remains for moderate tightening of trade rules rather than a full blown trade war. Citi analysts continue to remain overweight Global Equities and underweight Global Bonds.

 

Within equities, Citi analysts favor Europe as well as Emerging Markets (EM). Despite Citi’s preference for equities, there are still opportunities within developed high yield and emerging markets bonds.

 

Emerging Markets (EM): Robust earnings and attractive valuations

 

Citi analysts expect EM earnings per share (EPS) to grow 12% in 2018 while Developed Markets’ earnings are expected to grow at 9% reflecting a more advanced stage of economic expansion. 

 

EM equities trade at a discount to DM: 15x vs. 20x trailing price-to-earnings (PE). Within EM, Latam is slightly more expensive at 23x trailing PE while CEEMEA and Asia look more attractive at 12x and 15x, respectively.

 

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A weak US dollar also remains positive for EM and Asia. Due to stronger local currencies, inflation remains subdued supporting economic growth.

 

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Europe: Earnings growth still has upward momentum

 

Despite recent market weakness, Citi analysts remain positive on Europe ex-UK equities. Citi analysts believe that the 2018 GDP growth forecast of 2.4% could support corporate earnings growth of 10% this year. Europe ex-UK equities also offer high average dividend yields of 3.5%.

 

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While a stronger Euro may weigh on exporters’ earnings, currency strength has helped attract inflows from non-European investors. Citi analysts also expect political risk to be relatively contained. 

 

In contrast, Citi analysts are neutral on UK large-cap equities as Brexit uncertainty is likely to remain a headwind. Although dividend yields above 4% appear attractive, UK consumer confidence has continued to fall since the 2016 Brexit vote and real wage growth has remained slow. Given this backdrop, UK equities are likely to range-trade with higher volatility.

 

US: Valuations appear stretched

 

The combination of tax cuts, a decrease in regulations and repatriation of overseas cash has buoyed expectations for faster US business activity in 2018. Citi analysts expect earnings growth of 14% in 2018.

 

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While the US economy remains strong, US stock market valuations appear stretched. The trailing price to earnings (PE) ratio of 23x is above its long run average of 18x. See chart 2.

 

Furthermore, risks of rising inflation alongside interest rate hikes and trade tensions could limit this year’s US stock market gains. Citi analysts remain neutral on US equities for 2018.

 

Within US equities, the Financial sector is preferred as it typically outperforms in a rising rate environment. Easing regulations for banks is also supportive. Other sectors that Citi analysts favor include Energy, Consumer Discretionary, Materials and Industrials. 

 

Japan: Yen strength may cap gains

 

Citi analysts believe that the Japanese fiscal stimulus program as well as preparations for the 2020 Olympic Games could support Japanese equities in 2018. Japanese equities are not expensive at 13x forward price to earnings (PE), which is a 13% discount to its 10 year average.

 

Historically, a strong yen has been a headwind and this may temper the market’s upside in 2018. Investors can seek selective opportunities in Robotics, Information Technology, and Telecoms sectors, in which Japanese firms are globally competitive.

 

Fixed Income: Position for Higher Yields

 

Citi analysts expect tighter monetary policy in developed markets to drive bond yields gradually higher. The US Federal Reserve (Fed) raised policy rates by 25bps in March and Citi expects an additional 2 hikes in 2018. As US interest rates rise, the higher yields from emerging market debt and high yield bonds can provide investors with greater buffer compared with other lower yielding fixed income options.

 

Opportunities in Emerging Market bonds: Citi analysts view local currency Latin American debt as attractive given a strengthening growth outlook, favorable inflation trends and attractive absolute yield levels.

 

Among Asian bonds, Citi analysts favor China, as its onshore markets become more open to foreign investors. As China’s Bond Connect platform, which provides access to local China bond markets, becomes better known and utilized, flows to Chinese bonds are likely to increase. The full inclusion of China’s bond index within global bond indices can also help attract passive inflows of an estimated $250 billion.

 

Corporate Investment Grade (IG): Favor US over Euro: At 3.75%, US benchmark yields are at their highest levels since 2011. High quality bonds can offer a buffer against equity volatility. In contrast, Citi remains underweight Euro IG as valuations remain weak and these bonds have limited protection in the event core rates rise. Spreads may also widen from declining ECB purchases later this year.

 

High Yield (HY): Prefer US over Euro: Despite global volatility, US HY performance has been relatively resilient in Q1. Looking ahead, fundamentals remain strong and default rates remain low at 3.3%, well below historical averages. Benchmark yields above 6.0% still offer relative value when compared with other global markets such as Euro HY with its average yields of 3.35%.

 

Stay diversified

 

While trade tensions and central bank tightening may cause market volatility to rise, Citi views market pullbacks as opportunities to the degree that geopolitical events do not cause a global recession. Staying diversified across regions and asset classes can help mitigate the risks ahead.

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