Equity investors may be in for a rude awakening

9 minute read

The sky is currently the limit for global equities. After delivering stellar results in 2019 – global equity returns were 28%, the best result since 2009 — US and European markets climbed to even new heights in early February.

The optimism in 2019 is easy to explain. Central banks in developed markets embarked on their loose monetary policies, and global growth began to improve modestly following the weak economic environment at the end of 2018. Furthermore, by the end of 2019 one big headache after another got relief: Brexit started to look more orderly and China and the US had finally reached a mini trade deal. Investors responded by driving equities even higher. And as long as those risks don't return, the market could rally further.

Unperturbed by the widening coronavirus epidemic, investors are hunting for yield instead. Although equity valuations are rich on an absolute level, it still offers decent relative value: the earnings yield on global equities is currently around 5% compared to the lower and negative yields on government and corporate bonds across the globe. In addition, companies are typically able to increase their earnings above inflation levels, adding to the attraction of the asset class.

Nevertheless, equity markets seem to be euphoric, and not to worry about potential longer-term effects of the coronavirus at all. Rather, equity markets perceived the negative sentiment around the coronavirus outbreak as a "buy-the-dip" opportunity. Fundamentals are stable, but modest global growth expectations limit any significant improvement in fundamentals. For now, markets still expect the adverse effects from the coronavirus to be short-term and contained to Asian markets. A market correction could be unleashed when the coronavirus affects the global economy rather than local Asian markets only. For this to happen we would have to see contracting global growth data or accelerating default rates. But for assessing the actual impact of the virus, we would have to wait to the release of 2020Q1 data at least. In the meantime, we remain cautious for negative surprises.

On a tactical horizon, we have changed our neutral positioning and added an overweight in equities versus fixed income. Our allocation towards alternatives remains neutral.


Within Fixed Income:

  • This month we have increased our overweight in emerging-market debt.
  • We have decreased our underweight in US government bonds. The underweight in EU government bonds remains intact.
  • Government bonds as a whole have a small underweight.
  • This month we opened an underweight in both US and EU investment-grade debt.
  • We have an overweight in all subcategories within the high-yield asset class. Overall, the positioning is driven by an overweight in the higher-yielding categories versus the lower yielding (government bonds).

Within Equities:

  • We have a decent overweight towards emerging-market equities and an underweight towards EU and US equities.
  • All other equity categories are neutral this month.

Figure 1: Our asset class overweights/underweights in our model portfolio as of February 1, 2020 on a 3-month horizon. Each percentage reflects the relative weighting of the different asset classes within our model portfolio.

Fixed income – Government bonds

US: Modestly positive. Fundamentals remain positive. The phase-one trade agreement has eased US-Chinese trade relations. But it is unlikely that a grand deal will be achieved in the near term, so uncertainty persists. We think the US central bank is likely to cut rates one more time by mid-2020. The announcement of a new 20-year Treasury bond should continue to put steepening pressure on the curve. Valuations are neutral. Yields are above their near-term lows but only slightly above our 2020 year-end forecast of 1.75%. Sentiment and technicals are neutral. The market appears to be in a trading range, potentially a wide one, bound roughly between 1.44 and 1.97 on the 10-year Treasury.

Europe: Negative. Fundamentals have turned negative. The phase-one deal has limited the downside risks for global growth in 2020, but it is not yet clear what the trading stance of the US will be towards Europe. Valuations are very negative as German yields are far from any measure of fair value es estimated by nominal or real growth. Sentiment is neutral as recession expectations have definitely calmed down and the market is settling for a softening in economic growth. Technicals are also neutral. The medium- and ultra-long down trend in yields is still unbroken. In the past two months, the level of -0.20% has been tested twice, but unsuccessfully. Technical studies such as the MACD and RSI point to neutral levels with a slightly overbought status.

UK: Modestly positive. Fundamentals are positive. November GDP was down 0.3% month over month, meaning December 2019 needs to post a 0.2% mom increase or better to avoid a contraction for Q4. The inflation CPI was 1.3% against an expected 1.5%. On a positive note, the latest PMI reading for UK Services bounced back to above 50 on January 24. The Bank of England (BoE) has become significantly more dovish since the beginning of 2020 and has signalled that rate cuts may be forthcoming if there is no improvement in the data. Valuations are modestly positive. The current 10-year gilt yields 0.62%; the 1-year forward yield is slightly better at 0.72%. Sentiment has turned positive (from neutral last month) due to the rhetoric from the BoE. Technicals are neutral. Supply is picking up because the Debt Management Office (DMO) had to issue more bonds than expected.

Japan: Negative. Fundamentals remain mildly positive. In early December, the Japanese government approved a stimulus package amounting to 4.7% of Japan's nominal GDP. The package, half of which is public-sector spending, aims to fuel economic growth. While the package is seen as a positive for the short term, the long-term implications (fiscal discipline) are uncertain. Valuations are very negative. The Japanese 10-year rate trades in the middle bound and slightly below zero due to buying by the Bank of Japan. The Taylor rule suggests a much higher official rate, a clear sign of the how expensive the Japanese market is. Sentiment is also negative. Japanese sovereign bonds are highly sensitive to the US-China trade talks and the latest mini agreement has improved sentiment. The stimulus package has also led to optimism. Technicals are neutral.

Fixed income – Investment-grade

US investment-grade: Neutral. Fundamentals remain neutral. US growth continues to hover around trend. EM PMI numbers continue to rise. Overall, we expect moderate economic expansion, which would be favourable for corporate bonds. Third-quarter corporate earnings were underwhelming. The fourth-quarter earnings for banks started out with fairly good numbers, and consensus is calling for revenue growth of slightly more than 4% for the fourth quarter. Corporate leverage, however, remains high. Valuations are negative. Credit spreads were 5 bps tighter over the previous month, with an OAS of 90 bps. (The YTD range in 2019 was 90-147 bps.) Spreads remain fairly rich versus their long-term average and are even less attractive when adjusted for leverage and duration. Sentiment is neutral. The phase-one trade deal is expected to provide a positive bias in sentiment, while election headlines are expected to add volatility. JPM's recent investor survey shows signs of caution in fixed income: the share of investors who are overweight in corporate bonds has declined to 20% while the share of those who are neutral rose to 73%. Technicals are positive. The primary calendar started with a deluge of supply in January. The yield advantage in the US continues to drive inflows into the asset class.

European investment-grade: Neutral. Fundamentals are neutral. Unemployment is at a record low and the overall macro picture is stabilising. The US ISM is rising, mainly due to services, and currently stands at 52.2. The PMI composite in the EU is slowing increasing, and currently stands at 49.6. However, the manufacturing PMI is falling. Valuations are negative. The European IG spread has tightened and is currently 91 bps. Yields have increased, currently averaging 0.46%. Sentiment has improved in the euro area. The German confidence indicator has risen. We expect things to remain relatively quiet on the Brexit front in the coming weeks. Therefore, sentiment is neutral overall. Technicals are positive. The blackout period combined with a lack of issuance will probably push spreads tighter over the coming weeks. Money continues to flow into the asset class, and the ECB remains a firm buyer.

Fixed income – High yield

US high yield: Negative. Fundamentals are neutral. The US economy continues to provide a relatively favourable backdrop and many of the uncertainties concerning 2019 macro headwinds have subsided. Capital markets have been open for several energy companies to fulfil their refinancing needs in 2020, which is a good sign. Valuations are negative. Spreads have continued to tighten and remain well inside long-term averages. Sentiment is neutral and technicals are positive. Flows in recent weeks have been positive following the risk-on rally in equities. 2019 primary issuance was up 52%, and 2020 expectations are modestly lower. The market is starved for paper.

European high yield: Neutral. Fundamentals remain neutral. European economic indicators seem to be stabilising and the fear of a recession is fading. Company results are deteriorating in general, combined with slowing margins in cyclical sectors. Defaults are low, but rising. Valuations are negative. Spreads are at 305 bps, which is 10 bps tighter than at the beginning of 2020. Sentiment is neutral. While the market believes a recession has again been avoided, there are still fears about earnings (revisions). Technicals are positive. Investors have a lot of risk appetite and dispersion is rising. The search for yield continues and flows are positive.

US leveraged loans: Negative. Fundamentals are neutral. Earnings are generally growing except in retail, chemicals and due to some other idiosyncratic pressure. Default expectations remain low (2-2.5%) for this year, and total leverage levels are below the levels in late 2007. Valuations are negative. Much of the decline in the index has been in lower-quality loans, with performing BBs/Bs at or above par. Single Bs are risky. Repricing has picked up and is negative for this asset class. Sentiment is neutral. The decline in expectations by the market and by the Fed about future interest rate hikes has reduced demand for this asset class. Technicals are neutral. Mutual fund flows have moderated. Primary activity has been active and the quality of deals is improving as CLOs shun issuance by lower-single-B companies.

Fixed income – Emerging market (EM) debt

Emerging markets: Modestly positive. Fundamentals are positive. As the global economy seems to be slowly gathering momentum, high-frequency emerging-market activity data is picking up speed. The recent decline in oil prices will boost emerging-market macro fundamentals. EM growth will be higher this year than in 2019. However, growth in ex-China emerging markets is expected to keep strengthening alongside developed markets, albeit at a modest pace. Valuations are positive. EM sovereign spreads have widened 8 bps since the last House View. The growth premium over developed markets remains appealing and is supported by an attractive yield. We believe EM local-currency debt will outperform their hard-currency 'brothers' over the next three months. Sentiment is positive due to the phase-one grade deal, expansive monetary policies in emerging markets, an easing of Middle East tensions and signs of a global economic recovery. Technicals are also positive. 2020 started off with accelerating inflows into EM bond funds. The positive EM returns and demand for yield should continue to attract inflows, and coupon and maturity cash flows are expected to remain elevated in the near term.

Fixed income – Securitized

US securitized: Modestly positive. Fundamentals remain healthy and stable in most securitized sectors. ABS credit trends and consumer balance sheets are in good shape. Affordability is supported by low rates. Home valuations continue to rise. Within CLOs, the deteriorating quality of underlying bank loans remains a concern. The low interest rates are keeping gross Agency MBS supply elevated. Valuations have turned negative from neutral last month. Spreads in most sectors have rallied over the past month. Due to spread tightening, the sectors are very near the recent tights they achieved last year. Implied volatility has moved lower, which is negative for the asset class. We expect the pace of spread tightening to slow and spreads to be rangebound to slightly tighter over the next few months. Sentiment is neutral while technical are positive. Primary-market supply has risen in recent weeks but pent-up demand continues to drive significant oversubscriptions. Dealer balance sheets are relatively light at the moment. Agency MBS technicals remain negative as supply will remain elevated, driven by low rates and the FOMC's runoff.

European securitized: Modestly positive. The story in this asset class is still intact. Fundamentals remain slightly positive. Consumer fundamentals are healthy. Though EU growth is slowing and inflation is low, in general the macro data has surprised to the upside. The economy in the UK is also stabilizing. Valuations are positive as spreads have been mostly stable and rates are less volatile. CLO spreads are broadly stable. There is hardly any primary issuance. Sentiment is neutral, while technicals are positive. Demand is quite strong due to lower consumer-related EU denominated supply and negative net supply in legacy, which is supporting some sectors. UK supply continues to be strong.


USD: Neutral. We remain neutral on the dollar. The global economy is gradually improving. US data has been firm enough for the Fed to stay confident. Investors remain attracted to the positive interest rate differential. The US dollar remains one of the highest-yielding currencies in the G10. Based on our valuation metrics, the US dollar is expensive and vulnerable to a major downward correction at some point. The dollar tends to fall when global growth booms and/or there is a significant domestic underperformance. Neither condition has been met.

Euro: Neutral. There are reasons to believe the next big move in the euro will be higher rather than lower. First, the currency is cheap according to our valuation metrics. Second, market positioning remains short, suggesting room for a positioning squeeze. Third, some of the euro's fundamentals have hit rock bottom. For example, policy rates have limited room to fall any further. That said, negative eurozone interest rates deter ownership of the euro – by design – and investors continue to use it as a funding currency. Regarding the EUR/USD currency pair, we are neutral this month. Fundamentals are positive, valuations negative, and both sentiment and technicals are neutral. The euro is significantly undervalued versus the USD.

JPY: Neutral. The Japanese yen remains one of the only cheap recessionary hedges left in the global macro space. Deteriorating market sentiment or a further shock would likely support the JPY due to weaker risk sentiment. The currency's significant undervaluation combined with the constraints of the Bank of Japan suggest the risk/reward is asymmetrically skewed to JPY appreciation. For the USD/JPY currency pair, we are neutral with a positive bias. Specifically, fundamentals are negative, valuations and technicals are positive, and sentiment is neutral.

GBP: Neutral. A number of Monetary Policy Committee members at the Bank of England have cast doubt around the prospects of a rebound in growth without additional monetary stimulus. We assume that in the long term, investors will start to opportunistically move their UK allocation back to neutral, which makes us constructive on the currency in the medium term. The announcement of an infrastructure-led fiscal spending package is expected in March. This will build on the market confidence that has set in since the general election. The labour market remains solid and real incomes are rising. We are neutral on the GBP/USD currency pair. Fundamentals and valuations are neutral, sentiment has flipped to negative from positive, and technicals remain positive.


US: Slightly positive. Fundamentals remain positive. Expansionary deficit spending has supported nominal growth. This could sow good seeds for the next cyclical upturn. Consumption growth is slowing. The consensus 9.5% EPS growth for 2020 could be too optimistic. Valuations have fallen to neutral. Absolute metrics are on balance richer than last month. Based on relative metrics, US equities look more favourable than Treasuries. Sentiment remains negative and technicals are positive. Weekly stochastics may have topped out in overbought territory.

Europe ex-UK: Neutral. Fundamentals have improved to neutral from negative last month as any improvement in the EM/global outlook should benefit Europe. EPS growth for FY2020 is around 10%. The EU financial earnings revision ratio is the highest across all sectors and would support earnings. Long-term, however, the financial sector faces headwinds, which will be critical for European equities. Valuations are negative. The market seems expensive from a P/E perspective and is relatively cheap compared to other regions. The forward P/E has improved but is still higher than average. Sentiment is negative because investor sentiment is too optimistic. The economic surprise index is also the highest in Europe versus other regions. Technicals are positive.

UK: Positive. Fundamentals are neutral. Now that the UK has officially left the EU, the focus shifts to trade negotiations with the EU. Recent economic data has been mixed to soft, though the labor market remains robust with real wage growth. UK economic growth could improve into 2020 with the prospect of less political uncertainty, fiscal easing and a rate cut from the BoE. Valuations are fair and the dividend yield remains attractive. Sentiment continues to improve as political uncertainty fades. Short-term technicals are improving.

Japan: Neutral. Fundamentals remain negative as Japan's GDP and CPI remain stubbornly below 1% and the domestic-facing part of the economy is unattractive. Therefore, we are structurally underweight in such areas as retail and financials. Much of the listed market composes global companies and any pick-up in trade would benefit them. Valuations are also negative. The TOPIX index has a 15x P/E, which is the higher end of its mid-term range. The 2.2% dividend yield is attractive compared to Japanese government bonds (0%). But equity yield v bond yield is not a good timing tool. Sentiment is fairly neutral. Most of the post-Abe buying has now been unwound. Manager were net sellers over the past month, leaving modest scope to surprise on the upside. Technicals are fairly neutral. The 120 dma is in an established uptrend.

Emerging markets: Positive. Fundamentals are positive. Activity stabilization in EM more pronounced than in developed markets, but the correlation between EM equity returns and the Global Manufacturing PMI (which is higher compared to the EM PMI) is high. Therefore, a macroeconomic improvement in developed markets is needed for emerging-market assets during the rest of the first quarter. EM central banks are the most dovish they have been since 2009, which is a positive for the asset class. Valuations remain negative. Sentiment is positive now due to accelerating EM inflows — emerging markets continue to be the most preferred region among FMS investors. Technicals are positive as the MXEF index has breached its multiyear resistance level.

China: Modestly positive. Fundamentals are positive. The New Exports Orders PMI jumped to 50.3 from 48.8, the first time above 50 since May 2019. The PMI recovery in manufacturing may be boosted by policy stimulus in infrastructure investment and the phase-1 deal. Global monetary policy is accommodative and liquidity conditions have improved significantly, but we think the relevant economic recovery will be weaker than in 2012 and 2016. Valuations are neutral. EPS growth 2020 is still below EM growth, but the EPS dynamic is better and the P/E discount widened compared to the EM index. Sentiment is positive. China is the biggest contributor to EM flow. Chinese equity inflow has continued and broader Asian funds have also started to attract inflows. Technicals are positive. Both the MSCI China and MXEF indices started the year with solid performance. Higher highs and higher lows maintain the positive outlook.

Alternative Assets

REITs: Mildly positive. Fundamentals remain positive. Listed real estate markets are up +4.3% since the last House View versus +3.7% for global equity markets. Investment and financing markets are still supportive for the asset class. Valuations are positive. The market is still underpinned by rates and credit yields. The spread versus credits has improved further. REITs are relatively cheap. The US is trading at a modest premium but further yield compression is expected. Sentiment is positive. REITS overshot to the downside given the pressure on yields that was seen at the end of 2019. This could imply some recovery for REITS. Technicals are positive. The assert class is trading above 200 dma in all markets.

Distressed credit: Neutral. Fundamentals remain negative. Growth is still intact for 2020, but risks to the downside still exist. Also, default rates are expected to rise modestly throughout 2020. Valuations are neutral. CCCs underperformed high-yield debt on a total and excess return basis in 2019, but outperformed in December and January. We do not have a strong conviction on the direction of CCC spreads for 2020 and therefore expect they will remain rangebound. Sentiment is now positive given the rally in commodities and positive news on Brexit and the China-US trade deal. That said, investors' patience with non-performers remains short. Technicals have also become favorable. Net flows into the asst class were positive in 2019 and new issue supply is still light given the strength of market fundamentals.

Commodities – oil: Neutral. Fundamentals have fallen to neutral this month. Global growth expectations have been downgraded, which has led to downgrades in the oil-demand forecast. Also, the inventory build-up last month was below the
"normal" seasonal patterns. US shale production has peaked and the rig count is drifting lower, in addition to increased production cuts by OPEC+. Valuations are positive. The oil price is relatively strong against the strong dollar, which could become a headwind to oil prices. The carry or roll yield dynamics of the oil futures curve is supportive. The front end of the curve has moved into backwardation and the long end into contango. Sentiment and technicals are both neutral.

About the House View

Aegon Asset Management operates from centers of expertise in North America, the UK, Continental Europe and Asia. The Aegon Asset Management House View is updated on a monthly basis, and is an excellent example of how we leverage our international expertise. First, we collate a global set of asset class views from our international teams. The asset class views are subsequently reviewed from macro, rates and asset allocation angles and an overarching committee then establishes the global House View. The outcome of this disciplined global process provides portfolio managers with latitude while at the same time ensuring that our products and solutions remain aligned.


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