By the Cross Asset & ETF Research Team at Lyxor Asset Management.

Lyxor: Five ways to position your equity portfolio into year-end

We’re entering the final quarter of 2019 after a bumpy summer of trade disputes and recession fears. How should investors position equity portfolios to see out the year?

Bond and equity market valuations are sending conflicting signals. The bond market has $16.1 trillion of negative-yielding debt, which has pushed investors into riskier assets. This looks inconsistent with typical allocations at such an advanced stage of the economic cycle. Either the bond market is overly pessimistic, or equities are too positive. If it’s the latter, any readjustment would likely be painful. Ultimately, a slowdown in activity or mild recession is to be expected after more than a decade of growth.

Looking ahead, political uncertainty will remain a wild card and sentiment will likely be a drag on global equities, particularly as central banks have little room for maneuver on rates policy. Selectivity and asset quality will remain key to maintain performance in equity portfolios in the quarter ahead.

With all that in mind, here we share five ways to position your equity portfolio into year-end.

1. US equities: Likely to stay resilient

We expect US economic growth to bottom out over the next quarter, which should help the Fed anchor market expectations on its future policy actions. The Fed’s current policy on rates is aligned with mid-cycle monetary policy adjustments. More than 0.75% of rate cut would be interpreted as policy reaction to counter a recession phase.

The US remains our preferred equity market due to the US economy’s domestic focus. The US stock market also tends to be less volatile than other global regions. The US is a more closed economy and has more headroom for policy support.

We believe the Fed will cut again at the December meeting. Any move by President Trump to offer the US consumer some relief from the US/China trade war would also support the market. New tariffs on Chinese goods in the months ahead could add another 0.2-0.3% to inflation in the short-term.

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2. European equities: Caution advised

There are three main reasons to be careful on European equities, despite recent signs of stabilization: lingering risks linked to Brexit, vulnerable consumer confidence and economic growth, and the risk of another escalation of trade tensions, with the potential for US tariffs on European luxury goods.

In our view, easing financial conditions and fiscal support may not be enough to offset the lack of earnings growth and the slowdown in global trade. We have a preference for high-quality stocks and volatility reduction strategies. Small caps should also be more sensitive to any deterioration in activity, so we favour large caps.

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3. European sectors: Load up on defensives

With low earnings prospects and heightened geopolitical risks, we maintain our preference for defensive sectors.

We like sectors exhibiting strong balance sheets and better earnings growth potential such as Healthcare, Consumer Staples, and Utilities. These sectors would prove more resilient in a slowdown in economic activity. We keep a neutral stance on Financials as, despite its attractive valuations, the sector suffers low rates and weak profitability prospects. While the ECB’s new tiering system on bank deposits will provide some relief, the outlook for banks is more driven by long-term bond yields and the outlook for economic growth.

Defensive sectors outperform when the economic environment deteriorates

Source: Lyxor.

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4. EM equities: Cheaply priced, but be selective

Valuation in emerging markets (EM) equities are attractive compared to developed markets, with the former’s price to book value trading at 35% discount (see chart below). However, the developing world will remain very sensitive to trade war developments and economic growth prospects in China. The tariffs war exacerbates the downside in the Chinese Yuan and spreads to other Asian currencies. This weighs on growth of China’s trading partners too – see our Trade War Impact Indicator for a reminder of the most vulnerable countries.

Overall, we expect greater dispersion in returns among EM countries.  A trade truce would offer greater respite to the most affected. We also believe that an allocation to Chinese equities should be managed independently of a broader emerging equities portfolio.

Emerging markets at discount relative to developed market equities

Source: Lyxor.

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5. Indian equities: More upside expected

India is one of the few bright spots within the developing world. The local equity market relies on internal growth engines and is less dependent on exports than China. While the country still faces many challenges, the government’s latest move to reduce corporate taxes is a bold measure to revive growth. The test in the coming months will be to see whether corporates share some of the profitability boost into the economy via greater investment or price cuts on products to stimulate demand. In our view, ongoing policy initiatives and a dovish central bank should provide further upside to Indian equities in a context of attractive valuations.

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(The views expressed here are those of the authors and do not necessarily reflect those of ETF Strategy.)