Catalysts needed to sustain risk on rally
- Equities markets have enjoyed a stellar start to the year with the global benchmark up 9% and cyclical plays outperforming.
- The risk-on rally contrasts with the slowing macro momentum and earnings outlook. We see an unappealing risk/reward trade off in the short term.
- We have moved to neutral on global equities, cutting US exposure to underweight after the strong start of the year.
Stellar start to the year for equity markets
Equities markets have enjoyed a stellar start to the year, swiftly recovering their 2018 losses, with the global benchmark up 9%. Up 10% year to date, the United States has slightly outperformed other markets. The Euro area also added 10%, while emerging market performance has also been strong at close to 7% in local currency terms (Exhibit 1). At the sector level, technology has had a stellar rebound (13%) and cyclical plays have outperformed with industrials (up 12%) and energy (10% higher) outperforming. In line with the risk-on rally, global small and mid-caps have posted a 11% return while volatility has continued to normalise after surging higher towards the end of last year (Exhibit 2).
Risk-on rally contrasts with slowing economic momentum
The risk-on rally contrasts with the slowing economic momentum and earnings outlook, especially in the euro area, evident in the lacklustre fourth quarter earnings season. Over 80% of the companies in the STOXX Europe 600 have reported results, with aggregate earnings falling by 1.2%, with around half of the reported companies positively surprising analyst expectations. The region’s financial sector continues to disappoint with earnings contracting by 20%, missing consensus expectation by 8.5% (Exhibit 3). Along with headwinds to growth, negative interest rates have depressed banks’ net interest income.
Overall, our macro base case of decelerating global growth suggests softer top lines going forward, while profit margins for most major markets are at cycle highs. Cyclical sectors contribute a large chunk of earnings growth expectations for 2019 which seems rather optimistic at this stage. Meanwhile valuation multiples are back at long term averages, after the de-rating in 2018 in line with declining excess liquidity globally driven by the ongoing monetary policy tightening (Exhibit 4). We see limited scope for meaningful upside in the short term and believe positive earnings revisions and more visibility on a US/China trade deal is a required for a sustained rally.
Unappealing risk reward trade off in the short term; move global equities to neutral
We have taken some risk off the table and tactically moved global equities to neutral in our cross-asset allocation, cutting US equity exposure to underweight after the strong start of the year and maintain our underweight on the euro area. We remain positive on emerging markets given a relatively more dovish US Federal Reserve, a possibly peaking US dollar, attractive valuations and the growing growth differential between emerging and developed markets, which has historically been a key driver for outperformance of the asset class (Exhibit 5). Across both sentiment and technical measures, a variety of tactical indicators now appear to be stretched, with a meaningful divergence between fund flows and performance, while technical signals appear to be in overbought territory (Exhibit 6).
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