The chief strategist at the firm thinks that most developed markets are due a set-back given how strongly they have performed in recent years, but says the world’s most unpopular regions from an investment point of view – China and Japan – are the big exceptions.“World equity markets look overbought and we have dialled back risk by cutting our exposure,” he said.
“Valuations for developed market stocks and bonds look stretched as corporate earnings growth remains sluggish and US liquidity conditions seem to be worsening.”
“Emerging market and Japanese equities are the most attractively valued, and we retain overweight positions in both. This is justified by the fact that, whilst emerging equities have recovered significantly from February, inflows are rising and there are signs that Chinese growth is bottoming out.”
Performance of indices in 2014
Source: FE Analytics
“We also expect to see a modest improvement in economic growth momentum and moderate export growth.”
“Japanese equities are supported by the ongoing liquidity injection by the BOJ, which may ease policy further at the very end of this year. The weak JPY is boosting corporate earnings. The Japanese market offers scope for further gains as it is trading close to its deepest ever discount to world stocks.”
Performance of indices over 10yrs
Source: FE Analytics
US equities are not appealing however, Paolini says.
“Although economic and corporate earnings growth look good and the central bank is accommodative, the recent rally has taken valuations to excessive levels,” he said. “In addition, corporate margins are likely to fall from record levels.”
“With market volatility at historic lows, investors might have become too complacent about risk. In particular, we think that investors are too sanguine on the Fed exit strategy, as inflation risks in the US are underestimated. We expect US core inflation to rise by about 0.5 percentage points to 2 per cent by the year end.”
Her comments directly conflict with Artemis’ Cormac Weldon, who said earlier this week that investors shouldn’t just write off the US because it is historically expensive on a price to earnings basis.
Pictet is also wary of Europe in spite of the introduction of quantitative easing, and thinks the riskier parts of the fixed interest market are due a tougher period as well.
“We are also cautious on European equities which are very expensive, economic growth is slowing and corporate earnings remain sluggish,” he said.
“Supply and demand conditions in high-yield bond markets could become less favourable over the coming months. Inflows have moderated and this will persist throughout the summer. Persistently high levels of high-yield bond issuance should also exacerbate imbalances in supply and demand.”
While Paolini is worried about valuations in much of the developed world, he remains bullish on a medium to long-term basis.
Any significant pull back in the market would be a buying opportunity, he says.
“That is not to say the bull run has come to an end; rather, we expect to see a temporary setback that should provide investors with a better entry point,” Paolini said.
“Future equity gains are increasingly dependent on growth in corporate earnings, which has remained elusive, or a further decline in bond yields, which we think is unlikely.”