Overweight Emerging Market Equities
We believe EM equities have suffered enough over the past year, and it is now time to outperform. Their growth rate peaked in 2010 and have underperformed develop market equities through most of the decade. The worst performing asset class in 2018, last year EM equities posted double digit returns, though still underperforming major market like the US. The asset class is still a highly volatile one but with macro concerns slowly recovering from rock bottom lows we expect a continuing improvement in performance with the worst case scenario being sideways to modest upwards relative performance.
Favor European Stocks With Foreign Exposure
Our analysis shows European stocks with high foreign exposure have outperformed the broader index (and by implication, their domestic focused peers) over the past few years. This makes sense, Europe Inc. is highly competitive and the progressive intra-continental integration has enabled the national corporates to retain and gain market share within the region’s borders and beyond. This trend has been in place for years and we expect it to continue. Its best defense against headwinds of trade wars is a well integrated and profitable global supply chain.
US High Yield is Not Priced for Rising Risk
We expect high yield to underperform. The reason for our negative outlook is the significant reduction in demand for the riskiest corporate debt tranches (packaged together as collateralized debt obligations, or CLOs). This could have a ripple effect on the real economy given the importance of the leverage loan market as a source of corporate funding.
Cash is King! Position For Long-Term Equity Market Risk
While we prefer to be positioned for a final leg up in equities in the near term, we are cautious of long-term risks. Our conclusions from analysis of the flow of funds data are two fold. On the one hand, there seems to be no exodus of retail investors from fixed income to equities just yet. But, there is risk of reversion. If retail investors continue to avoid equities, we expect the remaining support line of financial engineering (mainly buybacks) will prove insufficient, especially at a time when top line growth (S&P 500 sales) while still positive, continues to soften. For this reason, we recommend a free cash flow bias during stock selection.
Our negative bias towards fixed income is concerning the corporate sector, and even within it, mostly towards the more speculative end of the spectrum as stated above.