Asset allocation – No surprises!


The various market segments reacted more or less as expected: US equities and fixed income underperformed the rest of the world; (US) Growth stocks lagged value; (US) Inflation-linked bonds have not kept pace with government bonds (see Chart 1).

Table 1: Returns for selected asset classes (in %; since the beginning of the year)

Data as of February 1, 2022. Sources: FactSet, Bloomberg, BNP Paribas Asset Management.

For all these movements, there is always the feeling that there is more to come.

The US 10-year real yield is up more than 70 basis points from last November, but at around -50 basis points the current yield is still well below pre-pandemic levels (the average in 2019 was +40 basis points). It is also still below levels seen when secular stagnation was the “new normal”.

The forward price-to-earnings (P/E) ratio for the S&P 500 has now fallen back to 20x, about 13% below its 2021 peak and not far off the levels seen at the end of 2019.

Chart 2: As U.S. Federal Reserve asset purchases taper off, real yields should rise and equity multiples could fall from their peaks

Data as of February 1, 2022. Sources: FactSet, Bloomberg, BNP Paribas Asset Management.

3 Factors Determining How Markets Do From Here

1) By how much the US Federal Reserve raises interest rates this year – between 75 basis points, as in its last “dot chart”, and perhaps 175 basis points if it raises rates in each of the seven policy-making meetings this year. Alternatively, key rates could rise by less than 75 basis points if the Fed is forced to suspend the tightening cycle due to either a significant drop in stock markets or slowing growth.

2) The final rate expected at the end of the tightening cycle – the “dot plot” predicts 2.50%, while the market has priced it at 1.75%

3) How quickly the Fed’s $9 trillion balance sheet, inflated by QE, is depleting.

We expect five to six rate hikes, which will bring the terminal rate closer to the Fed’s own forecast (and above market expectations). We expect balance sheet runoff starting in the summer at a rate of $2 trillion a year.

Overweight risky assets, underweight duration

This relatively modest pace of tightening, in an environment of slowing inflation, above-trend (albeit decelerating) global economic growth and the potential transformation of the Covid-19 pandemic into an endemic pandemic, argues in favor of a continued overweight allocation to risky assets and an underweight to duration.

We have reduced our previous underweight in US large-cap equities after the market plunge in January and are currently neutral. However, we expect US equities to continue to underperform the rest of the world. The divergence of monetary policies is one of the reasons. Our research team remains more dovish than the consensus on the ECB’s monetary policy measures, while the People’s Bank of China looks set to pursue broader easing. At the same time, the Fed is tightening its policy.

Relatively high valuations are another factor. Profit growth forecasts in the United States are slightly higher than those in Europe and emerging markets. This could support the performance of the US index. However, US equities are trading at a higher valuation premium, which we believe is unwarranted.

We remain overweight commodities as Omicron’s looser restrictions allow the global economy to reopen further, while supply remains constrained.

How strong are the current earnings forecasts?

The latest earnings reports from the US were generally seen as disappointing given comments from some large companies pointing to supply chain and margin issues. As a result, many analysts lowered their earnings-per-share estimates for first-quarter 2022 earnings, although full-year guidance was raised.

Nearly two-thirds of S&P 500 companies have reported earnings so far, and absolute results have actually been quite good. Profits were up 26% from the same quarter a year ago. This, however, does not seem to be enough for some market participants, especially given the current levels of many market multiples.

It is perhaps more relevant to look at how earnings surprises and forecasts fared. Both measures are close to their long-term averages, although they are now slightly below the unusually high numbers of 2021.

Japanese stocks and the yen will rebound in tandem

Our overweight allocation to Japan is probably against the grain. Historically, the outperformance of Japanese equities relative to the rest of the world has corresponded to a weakening of the currency.

From October 2012 to July 2015, equities significantly outperformed the rest of the world, but the weakness of the yen caused the return in US dollars to approach zero. In contrast, the trend from December 1998 to January 2000 was the opposite: the rally in Japanese equities coincided with a rally in the currency, boosting US dollar returns.

We expect to see the latter this year. The equity market outlook is positive given strong corporate credit metrics (valuable in a rising rate environment), good earnings momentum, a pro-cyclical market and low valuations (even by Japanese standards).

At the same time, the yen looks cheap in terms of real trade-weighted exchange rates; many investors are already short on the currency (meaning if the yen strengthens, the rally could be quite strong); foreign investors looking for returns above the stock market average should return; and we see the possibility for the Bank of Japan to reverse its reflation target.

All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients. The opinions expressed in this podcast do not constitute investment advice.

The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns.

Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.


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