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Asset Allocation

Building Resilient Portfolios

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Key Takeaways

  • Global bond yields – including emerging markets and high yield debt – have fallen to a record low 1.6% (0.6% ex-US). In contrast to the decline in bond yields, equity dividend yields have changed minimally, while dividends per share continue to grow at a mid-to-high single-digit pace. Citi has thus reduced the bond allocation in favour of equities.
  • A modest near-term contraction in manufacturing activity could negatively impact earnings, but a recovery is seen within the coming year. Furthermore, this time, Citi analysts believe the Fed’s turn from tightening to easing has cushioned markets. Within equities, Citi analysts prefer Emerging Markets (EM), particularly Asia, in the long term.
  • Gold is negatively correlated with equities and as a portfolio risk hedge, its safe haven properties provides a cushion against market uncertainties.

 

Slower Money Vs Cheaper Money

Citi economists now expect global GDP growth of only 2.7% in 2020, down from the 3.0% forecast at the start of the year. This slowdown is broadly spread across the global economy. Trade conflicts are proving a drag, as are heightened political tensions. While this may weigh on global equities, its effect should be dampened by easy monetary policy.

A further 25bp rate cut by the Federal Reserve in 2019 is now the likely case and could come as early as October. Eurozone interest rates are also unlikely to increase until 2023. The ECB is expected to restart net asset purchases at a monthly pace of €20bn from 1 November.

 

More Earnings Downgrades Likely

Consensus expects 10% global EPS growth in 2020, while Citi analysts expect 4%, suggesting more downgrades to come. Downgrades are unhelpful, although not fatal for stock markets. Since 1989, consensus’ initial EPS forecast has been too high in 21 years, but in 15 of those years (including 2019), global equities still rose.

 

Bear Market Checklist: Still Fine

With only 4/18 red flags flagging caution, Citi’s bear market checklist suggest that it is still too early to call the end of this ten-year bull market. Risk typically arises with 8 or 9 red flags.

 

Equities

Emerging Markets: Asia is preferred

EM equities have contended with a perfect storm of slowing growth, Fed tightening and trade risks over the past year which has contributed to already large underweight positions among global funds. Along with cheap valuations, Citi analysts believe this under-ownership could provide some near-term downside protection in the event trade tensions linger. Longer-term, Citi analysts see the strongest potential returns coming from Emerging Markets and EM Asia in particular.

Investors have under-allocated to EM and those with a long-term view may consider building exposure to an asset class strongly linked to many of today’s unstoppable trends; such as the growing middle class, urbanization, digital disruption and health care.

 

US: How long can the outperformance last?

Similar to 2018, US equities have been more resilient amid trade risks. The Federal Reserve has shown its willingness to cushion the economy through this uncertainty, by cutting interest rates in July and September, helping to keep equity markets broadly supported.

From a longer-term perspective though, it appears unlikely that US equities will be the best performers in the coming decade. Indeed, no asset class has been the top performer in consecutive decades (or in consecutive years for that matter). Chart 1 shows that US equities tend to outperform and underperform EM in long cycles, with the current phase of outperformance potentially approaching its end.

 

 

Europe: All eyes on Brexit

Cheap valuations, lower Italian political risks and a potential US-China trade deal are positives. However, the recent announcement by the US to implement tariffs on $7.5bn worth of EU products starting on October 18, may weigh on European equities. The announcement includes a 10% tariff on large commercial aircraft and 25% on agricultural and industrial goods. The main targets were capital goods from France and Germany, and food products from the UK and Spain.

UK equities continue to be attractively priced alongside a 5% dividend yield. Economic projections under the worst Brexit scenarios have improved, while fiscal support is available to cushion the economy. However, domestic political risk remains high with many outcomes still possible.

 

Japan: Dividend yield on a rising trend

Recent market sentiment had been weak because of trade headwinds and the consumption tax hike in October. However, the impact of this round of tax hikes may be less severe than the 2014 episode, as the government had cut taxes on large ticket items like autos and homes to cushion the impact. Historically, when dividend yield reached 2.5%, the returns of the TOPIX in the subsequent 12 months had been positive.

 

Fixed Income

Emerging Market bonds - Overweight

As developed market (DM) yields drop, the relative value proposition in EM increases. Average global EM USD benchmark yields at 4.9% are 340bp higher than DM markets (1.5%). Latin America has the highest regional yield (~7.5%), but also comes with higher volatility. On the other hand, average Asia EM USD yields are closer to 3.4%, but offers much more price stability.

 

Investment Grade (IG) - Overweight US

Citi analysts find best values in US IG between 5-7 years to maturity and tactically favor sectors such as Utilities, financials and non-cyclicals which tend to exhibit outperformance in periods of risk-aversion.

 

High Yield (HY) - Neutral US

US HY bank loan performance has lagged the HY bond market all year, with the S&P loan index gaining 6.5%, versus 11.5% for HY bonds. Having said that, US HY bank loans offer more attractive yields and lower price volatility around risk-off periods.

 

Commodities: Gold - Overweight

Gold is negatively correlated with equities and as a portfolio risk hedge, its safe haven properties provides a cushion against market uncertainties.

 

 

Neutral Equities, Underweight Fixed Income and Overweight Gold

Citi’s Global Investment Committee (GIC) has reduced Global Fixed Income to Underweight, raised Global Equities to Neutral and Gold to Overweight.

A modest near-term contraction in manufacturing activity could negatively impact earnings, but a recovery in seen within the coming year. Furthermore, this time, Citi analysts believe the Federal Reserve’s turn from tightening to easing has cushioned markets.

 

 

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