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Asset Allocation

3Q18: Market Volatility – Friend or Foe?

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In the first half of 2018, global equities experienced positive returns of 0.7% with equity markets at the highest level of volatility in more than two and a half years. Market volatility primarily came from rising trade tensions between the US, China, and EU.

 

Risks of further trade tariffs, a rebound in the US dollar and central banks tightening policy in developed markets continue to sway global markets and could weigh on returns in Q3. However, Citi analysts expect economic growth to prove durable.

 

Citi analysts expect the global economy to grow 3.4% in 2018, the highest growth rate since 2010, while global inflation is expected to rise slowly to 2.7% in 2018.

 

Given continued global economic growth and low risk of inflation, Citi analysts forecast the 9 year global bull market is not finished. Citi remains overweight equities and underweight 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, developed investment grade and emerging markets bonds.

 

Emerging Markets (EM): Healthy earnings growth and attractive valuations

A strong US Dollar since February 2018 has proven a drag on EM equities (see chart 1), and EM economic momentum has slowed. However, Citi analysts expect healthy EPS growth in 2018 (+17%) and believe that that the recent sell-off leaves EM valuation looking attractive.

 

 

EM equities trade at a discount to DM: 14x vs. 23x trailing price-to-earnings (PE). Within EM, Latam is slightly more expensive at 18x trailing PE while CEEMEA and Asia look more attractive at 12x and 14x, respectively (see chart 2).

 

 

Europe: Expect 10% earnings growth

Citi’s 2018 Europe ex-UK GDP growth forecast of 2.1% could support 10% corporate earnings growth this year. Europe ex-UK equities also offer high average dividend yields of 3.5%.

 

 

In June 2018, the European Central Bank announced it will stop asset purchases beyond December 2018. While interest rates are likely to remain unchanged until at least summer of 2019, the sustained low rate environment is positive for Europe ex-UK equities. Citi analysts also expect political risks in Italy to be relatively contained. 

 

In contrast, Citi analysts are neutral on UK large-cap equities as Brexit uncertainty is likely to remain a headwind. The possibility of a UK leadership challenge during the two-year negotiation period with the EU is likely to increase volatility as well as add further downside pressure.

 

US: Valuations appear stretched

The US economy continues to grow solidly, and Citi analysts expect US EPS gains to lead the world, as corporate tax cuts could provide 8% of the 20% rise expected in 2018.

 

 

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.

 

In June 2018, the US Federal Reserve (Fed) raised interest rates by 25bps and signaled an intent to increase rates two more times in 2018 as well as another three times in 2019.

 

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

 

Japan: Yen strength may limit 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 14x forward price to earnings (PE), below the historical average of 21x. However, Japanese EPS growth is likely to lag (9% vs 15% globally).

 

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: Seek Shelter with Income

Citi analysts expect tighter monetary policy in developed markets to drive bond yields gradually higher. 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: Higher relative yields, a better fundamental backdrop in EM economies and the expected return of a weaker USD should all be supportive for EM bonds.

 

Volatility is likely to persist given Fed tightening, ECB tapering, US mid-term elections and trade tensions.

 

Among Asian bonds, Citi analysts favor China, as its onshore markets become more open to foreign investors. Foreign investors own roughly 2% of the CNY12 trillion market, which could likely to grow over time. The full inclusion of China’s bond index within global bond indices can also help attract passive inflows of an estimated US$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 the European Central Bank (ECB) scales back easing and yields remain among the lowest globally.

 

High Yield (HY) – Prefer US over Euro: Fundamentals are still solid for US HY and with yields above 6.0%, they still offer relative value when compared with other markets such as Euro HY with its average yields of 3.35%. US HY spreads have tightened substantially since last year and are close to their 2014 post-crisis tights.

 

Shifting Allocation on Trade War Escalation

For Q3 2018, Citi analysts reduced equity overweight and reduced fixed income underweight. Amid uncertainty over trade negotiations in the near term, Citi analysts see the portfolio reallocation as a transitional step, and this may be raised or lowered based on pending trade developments. Citi analysts believe that a highly diversified multi-asset class portfolio approach remains essential in today’s environment.

 

 

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