Play market rotations, with a focus on China
Markets are shifting focus away from inflation towards growth, with a slightly less disruptive economic picture for Europe and a more optimistic view on China. This is creating strong rotations: outperformances for China and EM were the most visible trends, followed by the big reversal in the dollar’s strength. Intra-market rotations also materialised, with cyclical stocks favoured over defensive names in Europe while in the US, expectations of a less aggressive Fed supported tech stocks. Going forward, four themes should be crucial: (1) inflation/growth balance; (2) central bank (CB) actions; (3) dollar weakening; and (4) the corporate earnings trajectory. Any negative growth and earnings surprise could drive markets lower while there are no short-term triggers for upside at current valuation levels. This calls for a defensive allocation, but investors should play rotations as follows:
- Maintain a cautious risk stance, but recalibrate regional preferences. We are now more constructive on Chinese equities than on DM, regarding which we are cautious and more in line with market capitalisation (reducing negative stance on Europe equity[2]). From a cross-asset perspective, we are slightly positive on duration as we believe government bonds are maintaining their portfolio protection advantages. We are becoming more cautious in high yield[3] credit while we also keep a focus on diversification through commodities such as oil and gold.
- In FI, active duration management is key. Inflation and policy rate expectations are manifesting the fastest in bond yields, which have seen a downward move, supporting our slight positive view on US duration and a marginally cautious stance in core Europe. While near-term concerns on growth should be constructive, we do not recommend taking this for granted because inflation is still high. CBs are determined to address inflation, particularly the sticky services inflation, and this warrants an active stance. On the other hand, the BoJ is likely to exit its negative rates policy following an upward revision to its 2023 inflation forecasts, making us now cautious on Japanese government bonds.
- In the “bonds are back” mantra, play credit with a selective approach. The effect of monetary tightening on corporate credit has been limited so far because of limited refinancing needs and the high use of internal cash. While the latter has supported spreads so far, it has also caused a deterioration in liquidity compared with a year ago, especially for CCC-rated issuers. Looking ahead, the effect of rising rates and low economic growth will be felt more by low-rated HY issuers. As a result, we continue to prefer IG over HY. From a regional perspective, European IG spreads are cheaper vs historical levels, whereas this is not true for US IG.
- For DM equities, investors should focus more on earnings resilience at the single-company level. The revisions on the macroeconomic front and the currency dynamics call for a more cautious stance in the US and Japan while improvements in the European economic outlook support a less negative view on the region. However, the positive scenario factored in by markets could easily turn sour due to geopolitical risks or more-hawkish[4]-than-expected CBs. It’s also worth noting that often the beginning of the year does not prove a good indication of returns for the rest of the year. The current earnings season should present a clearer picture for H1.
- Opportunities in EM, beginning with China. China continued its fast-track economic reopening and is supporting its housing market, leading us to stay constructive as we have also upgraded our growth outlook for the country. This could have a positive trickle-down effect on countries with strong trade ties to China. On EM debt, the USD trend, the EM-DM economic growth differential, and valuations are among the key drivers of sentiment.
Overall, we are entering a riskier phase as markets reassess the earnings outlook which could cause some areas of the market to correct while some opportunities to add risk could emerge in the next few weeks. Importantly, we could see an earnings recession even in a ‘soft landing[1]’ economic scenario. Hence, agility is key at this stage, but with a cautious tilt for now.
