Following the first genuine correction in over four years, equity markets enjoyed a sizeable and rapid rebound in October – with the MSCI World Equity index recording a 7.5% bounce – that has continued into early November.
Year to date, however, UK commercial property remains the best performer with an estimated 11.5% gain
Indeed, from September 29 to November 4 the World index surged nearly 11%, with the US, Europe, emerging markets and Asia Pacific equities recouping all the losses since the correction began in earnest on August 17. Throughout equity markets it has tended to be those indices that had fallen furthest that bounced the most with the German DAX and Japanese TOPIX indices leading the way in the main markets and China in emerging markets, whilst large cap cyclicals outperformed in most areas, especially energy and basic materials.
How to Respond to the Equity Market Bounce
The reasoning behind raising equity weightings last month was fairly straight forward, it was believed the China led global slowdown and recession fears were overplayed, a Fed rate rise was fully priced-in, credit markets were oversold, valuations had improved significantly while sentiment was inordinately weak.
With markets now significantly higher, equity upside has commensurately diminished but, even so, US recession risk is low, tail risks have eased in China and, while the cycle is ageing, it probably has further to run. Additionally, after several quarters of corporate earnings being seriously impacted by extreme downturns in energy, global EPS (earnings per share) trends should improve into next year.
Whether this merits a full rather than a modest overweight is now highly debatable, however, given current valuations, the likely start of US monetary tightening and more neutral sentiment readings, and some profit taking should be expected.
Where in the World are Profits to be Found?
In terms of regional allocation, the preference for Europe and Japan is retained reflecting ongoing QE, stronger than expected earnings growth and decent valuations. Technical positioning is also favourable in Japan with foreign investors very underweight and domestic institutions still switching from fixed income to equities. On most criteria US companies remain the most highly valued – often rightly so – but with the growth cycle peaking, profits growth will likely be more muted than elsewhere.
The structure of the UK market essentially needs a sustained rebound in energy stocks and is overweight expensive defensives, neither of which are likely to outperform. Emerging markets remain neutrally weighted as equities are stabilising but returns are highly China dependent.
In terms of sectors/tilts, cyclicals remain favoured, but principally consumer cyclicals and IT with financials preferred in the US and Europe. There is little to choose between market capitalisation size in most areas but, in general, large and small cap look better value than mid.
From an asset allocation perspective, equities significantly outperformed all other assets in October and into November, so much so that year to November 4, global equities were up 2.8%, outperforming global bonds by more than 4% in sterling terms compared to being 7% down at the end of September.
Year to date, however, UK commercial property remains the best performer with an estimated 11.5% gain.
Although it is moving towards the later phase of the equity cycle further medium term equity outperformance of bonds is predicted, while credit remains favoured within bonds. Heightened volatility is likely, however, and at this stage the equity background may favour more trading oriented strategies while, for longer term investors, equity overweights should gradually be lowered into strength. For now, equities, credit and property remain moderately overweighted.
