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Asset Allocation | Equities

3Q17: A Bumpier Ride Ahead but Still Positive on Equities

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Even though equity markets have rallied in the first half of the year, Citi analysts continue to be positive on equities given the broadening global expansion and rise in corporate profits.

Turning positive on European (ex-UK) equities…

European equities performed well in the first half of the year, with the Stoxx 600 index rising by 7.5% and 13.7% in euro and USD terms, respectively.

Citi analysts have become more positive on the European equity market. Political risks are waning given the growing likelihood of stronger European Union (EU) leadership. The French-German axis at the heart of Europe is enhanced after the Macron victory. The EU’s increased assertiveness in its Brexit discussions with the UK is likely to help retain the cohesiveness among the other 27 EU nations.

Citi analysts expect the European economy to grow by 2.1% this year with the pickup broadening across the Eurozone. Even with the unfolding recovery, core inflation at 0.7% remains below the European Central Bank’s (ECB) 2% target.

While ECB Governor Draghi has become more optimistic on the outlook for the eurozone economy, Citi believes that the ECB will extend its asset purchase programme to mid-2018 although the ECB may reduce the monthly purchase amount. Meanwhile, interest rates are likely to stay on hold until mid-2019.

Given a recovering economy and interest rates remaining low, Citi analysts expect European earnings to grow by 15% this year. Valuations are still reasonable with the EuroStoxx index currently trading at 19x of earnings, a healthy discount to US equities. See Chart 1.

 

…But less so on UK equities

The UK economy faces multiple headwinds including political risks, policy uncertainty and tough Brexit negotiations. The cyclical downturn is deepening with the recent terrorist threats further dampening business and consumer confidence. Given this backdrop, Citi analysts expect volatility in UK equities and bonds while the sterling is expected to rise in the near term. Even if UK avoids a recession, domestic sectors are likely to weaken further, leading Citi analysts to be cautious on UK small and mid-cap equities. Large-caps may be more defensive with more than 70% of revenues coming from overseas and an average dividend yield of more than 3%.

Adding exposures in Asian equities

Citi analysts have increased exposure to Asian equities, expecting strong earnings growth. Economic fundamentals in Asia have been improving. In April-May, exports grew 10% from the same period in prior year. Healthy exports are expected to drive Asian corporate profits with earnings poised to grow more than 10% this year, the highest since 2011. The six-year USD rally has weighed on Emerging Market (EM) returns. During this period, EM Asian equities gained just 10% compared to 88% gains in US equities.  Citi analysts believe the USD rally has peaked, helping EM Asian equities to outperform. See Chart 2.

 

Within Asia, Citi analysts are overweight on across China, India, Taiwan, Korea, Thailand and Singapore.

  • Overweight China: With their inclusion in MSCI EM, China A-shares will account for only 0.7%, However, Citi analysts believe that this percentage will grow over the longer term. Citi also believes that tighter financial regulations in China are unlikely to derail the broader market.

  • Overweight Singapore: Supported by a stable monetary policy, attractive dividends and low valuations. Further fiscal easing cannot be ruled out as downside risks to property prices are rising given higher rates and tighter liquidity.

  • Overweight India: One of Citi’s strong overweight given the potential for policy easing, reform benefits, currency appreciation and earnings growth.

  • Overweight Taiwan, Korea: Valuations are still attractive despite this year’s technology-led rally.

  • Overweight Thailand: Citi sees potential for higher investment growth as the political outlook stabilizes.

 

Turning more selective in bonds

The 14 basis points decline in the US 10-year Treasury yield in the first half of 2017 has made bonds more expensive. As a result, Citi analysts have reduced their exposures in European and UK investment grade (IG) corporate bonds, UK government bonds (Gilts), short-term US Treasuries and European high yield bonds.

  • Underweight Euro Investment Grade corporate: 70% of euro IG corporate market yields less than 1.0% and offers little value in Citi’s view. Spreads may widen with the ECB likely to announce some tapering of its asset purchases later this year.

  • Neutral Euro High Yield: Citi analysts reduced their exposures in European high yields from overweight to neutral given expensive valuations and the risk of ECB-induced volatility.

  • Underweight UK Gilts: Without a clear political outcome, Gilt yields are likely to remain range-bound over the near-term.

  • Underweight UK Investment Grade Corporates: Spreads could widen as the UK economy weakens and Brexit-related uncertainties build.

  • Neutral US Treasuries: Any progress on US tax cuts is likely to boost the US economy and push long-term Treasury yields higher.

 

A bumpier ride

As the equity and bond markets rallied in the first half of the year, markets are likely to be bumpier in the second half. Citi’s portfolio positioning for 3Q17 remains biased towards equities supported by a broadening global expansion and a rise in corporate profits. While the Fed’s balance sheet reductions and decreased bond buying by the European Central Bank could lift bond yields and market volatility, the low starting point for yields make equities a more attractive asset class.

Key Takeaways

  • Citi analysts have turned more positive on European (ex UK) equities given waning political risks, robust earnings growth and continued attractive valuations.

  • Citi increased its exposure in Asian equities. Improving economic fundamentals and the expected end to the 6-year rally in the USD is likely to help Asian markets outperform.

  • Expensive valuations led Citi analysts to reduce weightings in European and UK investment grade corporate bonds, UK government bonds, short-term US Treasuries, and European high yield bonds.

 

 

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