Asset Allocation: Q4 Equity Strategy

In August, we cut our recommended equity weight to neutral. This reduction in portfolio risk responded to the currency volatility we had been experiencing. However, with a fairly significant correction having already occurred, and with the breadth of our asset allocation research still favoring equities, we believed it was appropriate to begin to rebuild an equity overweight as we published our September outlook. For now, though, we favor building that overweight primarily using U.S. large-cap stocks.

We believe that although U.S. stocks appear fairly valued, they can rise with earnings growth. U.S. corporate fundamentals look solid and supportive of earnings growth, with the U.S. economy on a clearly divergent path relative to other developed economies (Exhibit 1). Domestic economic conditions continue to indicate an environment favorable to equity outperformance.

Exhibit 1: Potential U.S. earnings growth is supported

Source: Bloomberg

Moreover, the Fed is set to end its bond-buying program and is no longer engaged in quantitative easing (QE). We continue to advocate careful risk taking as historical analysis suggests solid equity outperformance once the financial players become comfortable with the changes in Federal Reserve policy.

While the Fed heads toward the exit, the European Central Bank (ECB) is planning to provide further monetary easing and the Bank of Japan (BoJ) is continuing to expand its balance sheet as part of Prime Minister Shinzo Abe’s reforms (Exhibit 2). This divergence in policy is not an accident but a construct of the relative growth and inflation trends of these countries.

Exhibit 2: Balance sheets continue to expand

Source: Bloomberg

Euro area recovery in Q2 was disappointing with growth skirting recession at 0.1% and inflation falling further, despite near-zero interest rates. This prompted the ECB to take action to stimulate the credit cycle in the eurozone. On this news, the euro fell 7.5% versus the dollar, but European equity markets have held up reasonably well in local currency terms. This slide in the euro could help boost Europe’s export-oriented economy and stem the deflationary pressure; but deficient demand remains a continuing headwind, and it might be a few months before the impact of such policies provides a backstop to support growth and inflation. In addition, the specter of prolonged conflict in Ukraine and strained relations with Russia has dampened business sentiment in Europe, potentially disrupting economic activity. We maintain a neutral outlook on eurozone.

Like the eurozone, the Japanese economy and central bank have been on a divergent path relative to the Fed. The Japanese economy slowed more than expected from the second quarter consumption tax hike and has yet to show any meaningful bounce. Japanese equities are up about 3% year-to-date in local currency terms but have performed quite poorly in dollar terms. The yen has declined about 7% against the dollar. The BoJ is continuing with its bond buying QE program, but this may not be enough to reflate the economy. From an equity point of view, however, Japanese equities have an advantage over European equities. Valuations in Europe have expanded with little evidence of strong earnings growth; the reverse holds true for Japan, where valuations have declined this year and earnings growth has been stronger. Earnings are projected to grow near 10% over the next year, and a weaker yen is likely to boost earnings further. We continue to recommend an overweight to Japan but have downgraded Japan from a maximum overweight to a moderate overweight.

Emerging market outlook remains nuanced, with each of the three major regions — Asia, Latin America, Europe, the Middle East and Africa (EMEA) — responding to idiosyncratic challenges. Overall EM growth is positive but losing momentum, and EM equities are under pressure, together with their currencies, particularly in Latin America and EMEA. After a short-lived rebound, Chinese growth seems to be slowing again. While output may slow in the short term, this could benefit the Chinese economy over the intermediate term. The rest of Asia appears to see a pickup in growth, especially India and Philippines.

We maintain a neutral recommendation on overall EM equities, favoring Asia over Latin America, which suffers under the weight of lower commodity demand, currency headwinds and deteriorating domestic fundamentals. We also maintain a small overweight to EMEA, which has been adversely affected by the events in Russia, but ultimately ought to benefit from additional eurozone liquidity.

For our full outlook for Q4, please read Investment Strategy Outlook.