“Economic growth will soon slow, but inflationary pressures could linger for some time, which means investors should consider taking a more defensive stance,” says Luca Paolini, chief strategist at Pictet Asset Management
“Inflation has become the main concern of investors. Price pressure is increasing significantly – the US core CPI reached 3.0 percent year-on-year in April, its highest level since 1995.
“Our analysis paints a positive picture in the short term. Remove Covid sensitive items from the price meters and inflation looks modest as it barely rose in April.
“However, if you look ahead, the potential for price pressures to build is considerable. While there is little evidence of an increase in wages, US consumers have ample disposable income with around $ 2 trillion in savings. If only a third of that is spent on services – a larger part of the CPI than on goods – core inflation could fluctuate between 3.5 and 4 percent in a year.
“What worries us more, however, is the possibility of high inflation coinciding with a slowdown in economic and corporate earnings growth.
“Our leading indicators point in this direction. In China, growth is already weakening noticeably, and it is also easing somewhat in the USA; the global three-month expansion rate has recently halved to 7 percent.
“As financial markets face the possibility of continued price pressures and weaker growth, we are maintaining our neutral stance on equities and moving into more defensive areas of the equity market.
“In China, the signs of deceleration have multiplied. Industrial profits for the month were up 57 percent year over year, up from 92 percent the previous month. Price pressure has built up in other emerging markets, with the CPI rising from below 2 percent at the end of last year to an average of over 3 percent.
“The provision of monetary policy incentives by the central banks is just enough to underpin riskier asset classes. The volume of liquidity flowing into the financial system is growing much more slowly and is currently only one standard deviation above the long-term trend rate compared to four standard deviations a few months ago.
“Reviews show stocks are expensive compared to bonds. The gap between earnings yields on stocks and bond yields is at its lowest level since 2008, while our “stock bubble” index is now at its last level in 1999 and 2007.
Equity Regions and Sectors: Case For The Defense
“There are tentative signs that economic growth has peaked, particularly in China and, more recently, in the United States. And while corporate earnings have been extremely robust, as the excellent first quarter results show, we believe the consensus forecasts for corporate earnings per share and profit margins for 2022-25 are too optimistic.
“We are reducing our allocation to some of the more fragile and expensive looking cyclical equity sectors while increasing our exposure to more defensive areas. This reflects current market sentiment as cyclical stocks have outperformed their defensive counterparts in favor of the latter.
“We are downgrading consumer discretionary stocks to underweight and closing our overweight position in industrials. On the flip side, we’re turning less negatively on healthcare and utilities, upgrading both to neutral as defensive stocks are relatively attractive in valuations.
“However, we stopped being completely defensive. Financials and real estate are the most attractive sectors in an environment where bond yields are rising and economies are opening up again. The rents for real estate are usually linked to price indices, so that the industry can also offer some protection against inflation.
“Separately, we see growing potential in UK equities and we like the UK sector mix as it has an above average proportion of financials and quality names – sectors that we believe should do well at this stage of the business cycle.
Fixed income and currencies: stick with the ports
“With economic growth slowing in China and the US after a quick recovery from the pandemic in the second half of the year, conditions should favor some defensive fixed income assets. With this in mind, we keep our overweight positions in US Treasuries and Chinese bonds.
“In general, we remain overweight in Chinese government bonds. They offer attractive diversification as their returns do not correlate strongly with those of other asset classes.
“We are neutral to other emerging market bonds.
“We are maintaining our underweight position in US high yield as the asset class remains vulnerable to tighter monetary conditions as yield spreads hold near the lows of the previous cycle in late 2008.
“In terms of currency, we are broadly neutral to the US dollar. We believe the currency should stabilize before resuming its secular downtrend later in the year, as economic growth slows and worries about budget and current account deficits resurface. We are maintaining our sterling underweight.