11th April 2016
Luca Paolini, chief strategist at Pictet Asset Management, explains the recent decisions to scale back exposure to local currency emerging market debt to neutral, maintain the overweight stance on US high yield debt and why risky assets continue to look attractive.
March saw investors rediscover their appetite for higher-yielding securities, with emerging market and speculative-grade bonds delivering solid returns on the month. The rebound has served to push US high yield and local currency emerging market debt – markets in which we have been overweight for a number of months – firmly into positive territory for the quarter. US high yield is now sporting a gain of some 4 per cent year-to-date while emerging local currency debt is up 6 per cent. The bounce has led us to reassess some of our more tactical positions, particularly within emerging markets.
We have decided to scale back our exposure to local currency emerging market debt to neutral following its strong run and upgrade its dollar-denominated counterpart to overweight. Dollar-denominated emerging sovereign debt looks attractive, particularly when compared with investment grade corporate debt. Triple-B rated emerging market government debt and similarly-rated corporate bonds offer virtually the same yield pick up over US Treasuries of some 250 basis points. While such a spread looks justifiable for company bonds, it seems excessive for emerging sovereign borrowers, chiefly because it fails to take into account a government’s ability to reduce dollar debt and finance itself in domestic currency. The decision to scale back exposure to local currency emerging market sovereign bonds is linked to our view on the US dollar. The US dollar – which is down some 6 per cent from its January peak against major currencies – could reverse course over the short term, which would have negative implications for emerging currencies.
We have chosen to maintain our overweight stance on US high yield debt. Even though the market has staged an impressive rally, the asset class remains inexpensive. Spreads on US high yield bonds – currently at around 700 basis points – indicate a near-70 per cent probability of recession in the US over the next 12 months, which looks highly unlikely in our view. Default rates for high-yield bonds are currently running at a below- average 3.6 per cent, according to Moody’s – which means spreads provide ample compensation against the risks inherent in such securities, even if the financial health of energy companies, a big part of the market, continues to deteriorate in the coming quarters.
Our valuation signals suggest that risky assets continue to look attractive relative to government bonds but after the recent rally, the absolute valuation has returned to its historical range, with global equities trading at 16 times prospective earnings and a price to book ratio of two. At the same time, the market has seen a significant dispersion in valuations, both among regions and industry sectors. US equities and global consumer staples stand out as the most expensive, emerging Asia, Japan and financials are the cheapest stocks. A decline in consensus expectations for corporate earnings growth is a red flag, especially for US companies, whose profit margins are falling from record highs. The good news here, however, is that consensus forecasts for global revenue growth in 2016 are already at an extremely depressed level of just 1 per cent – well below the underlying growth rate of global GDP. That looks overly pessimistic.