Pictet seeks safety in developed markets

With a looming emerging market crisis, and a bull market in the developed world in its final stage, investors should still favour risk assets, but it is key they have some exposure to safe haven assets to protect themselves from unpredictable events, says Yves Bonzon, CIO of Pictet Wealth Management.

Current conditions recall the 1990s, characterised by recurrent shocks from emerging countries and leadership from the technology sector in developed markets, which today is leading to some high valuations in niche sectors such as biotechnology or social media, says Mr Bonzon.

“Although valuations are becoming very stretched, looking at expected returns on the mid to long-term, developed market equities should still be tactically favoured today,” he states, expecting 10-year total returns of around 5 per cent, dividends included. Volatility is going to be higher, though, with a 10 to 15 per cent correction in the S&P 500, possibly over the summer period.

Investors are increasingly worried about the outlook for stocks, he says. In 2013 developed market equities delivered 20 to 30 per cent returns, while earnings barely increased. Concerns also revolve around the tapering of the quantitative easing programme, expected to lead to a significant correction of risk assets.

But for the first time since 2008, when quantitative easing started, there is strong evidence that the S&P 500 is no longer responsive to QE changes. This shows that the Fed policy is appropriate and the balance sheet recession in the US is healing. “Interest rates are going to stay low for longer than investors probably expect,” he says.

While US equities are trading dearly, the market is not pricing in the current level of profitability of the US corporate sector as sustainable. Margins of US corporates are currently at peak levels, but the key factors underlying margin expansion are there to stay, being mostly due to a structural increase in the manufacturing sector. The increased use of robots, together with the energy revolution leading to lower energy costs, means that capital deployment remains extremely prudent.

High return on capital is also the reason why Pictet prefers, in general, developed equities to emerging equities, a position it has had for some time.

EM equities may be cheaper, but emerging countries are facing problems deriving from the huge capital flows they received between 2009 and 2012, which has led to excessive credit growth and poor capital allocation, he says. The downturn in commodities prices has added to the trend. As a result, return on capital has declined, while it is rising in developed economies, which have been capital starved during that period.

With the stabilisation of the eurozone and the pickup of US growth, the reversal of capital flows has exposed emerging countries with large current account deficits, and this will lead to “some bad credit event”, expects Mr Bonzon.

“The EM crisis will not blow out of control, although on a recurring basis it will hurt markets because of economic issues, which will lead to political and social tensions, such as those happening in Ukraine,” he says.

As a result Pictet has no direct exposure to emerging market equities today.

In Europe, the crisis of the single currency is in abeyance and efforts at budget retrenchment have also peaked, giving way to a slow if uneven recovery across the region, he says, stating his preference for stocks tilted towards domestically exposed businesses.

Short dated bonds are one of the most risky segments today, as they do not price in an interest rate normalisation. Investment grade corporates and, to a lesser extent, high yield bonds are one of “the worst risk rewards out there available in public markets,” as they are vulnerable in case of shocks. But probably contrary to consensus, Mr Bonzon expects positive returns from long-term US treasuries this year, as they already price in a substantial degree of rate normalisation.

“The risk of macroeconomic policy error remains. If that were to happen, long-dated US Treasuries would recover their traditional status as the most valuable safe-haven asset.”

In mid April, Treasury 10-year yields fell to a six-week low to 2.6 per cent, as unrest in Ukraine spurred demand for the relative safety of US government bonds.

His decision, earlier this year, to increase exposure to long dated US Treasuries to 15 per cent somehow surprised clients. “The more unpopular my decisions, the better I sleep at night,” he says.