Strategy: Contrary to appearances, risk-off does not prevail as yet

07 Apr 2016

  • Earnings outlook: modest to weak
  • No convincing signals of global growth rebound so far
  • US labour market won’t end the growth cycle yet
  • Asset allocation: more defensive

Manufacturing data have turned more positive, but investor concerns about the outlook for the global economy have lingered and analyst expectations for company earnings have continued to fall. As a result, the mood in the markets has shifted. Risk-off, anyone?


In line with risk-off sentiment, safe-haven assets have done well, pushing yields on 10-year US Treasuries to near their 2016 lows and driving German Bund yields down to below 10bp, which is only marginally above the record low from last April. In Japan, 10-year yields are negative.

The risk-off environment is less obvious in equities. Japanese equities lost 8% in recent days as the Japanese yen gained and European equities have dropped by 6% since mid-March. For US equities, the sell-off has been more muted so far. In fact, they are trading only 4% below their all-time high. Emerging equities have also suffered less.

Looking through the daily volatility, the uptrend of recent weeks looks to be intact. Still, the recent weakness went hand in hand with a decline in crude oil prices, which have been a major market driver for many months. The oil price correction after arguments between Iran and Saudi Arabia over production levels fits with the risk-off environment, in our view.

Corporate bond markets are clearly not in risk-off mode. Spreads tightened in February and March and have moved sideways since. The correction in emerging market currencies after recent gains is also too small to signal more bearish sentiment among investors.

Our proprietary market risk indicator has flashed risk-on for five consecutive weeks. Looking at volatility, the VIX or MOVE indices, which reflect volatility in the US equity and Treasury markets, and the VDAX gauge of volatility in German equities, are far below panic levels.


The US and Europe have been in a profit recession since March and June last year, respectively. In emerging markets, the three-month moving average of annual earnings growth has been negative since September 2014.

Going into the next US earnings reporting season, market expectations are low. Analysts on average expect earnings to drop by 8.6% YoY for all S&P500 companies. This is largely due to the troubled energy companies and the five big banks, but even excluding these, analysts expect earnings to contract by 2.7% YoY.

Earnings are still being downgraded. Early this year, analysts expected 20% YoY earnings growth for 2016 in Japan, 10% in the US and 8% in Europe. This is now 9% for Japan and just 3% for the US and Europe. Our own macroeconomic earnings models suggest flat earnings per share growth in the US, around 5% in Europe and slightly more than 5% in Japan. Given where analyst expectations are now, we see the biggest risk of further downgrades in Japan.


The US ISM manufacturing index has entered growth territory for the first time since last September. The Markit PMI, which we use to calculate the aggregates for developed economies and the world, improved by less, but both indices are now at comparable levels, pointing to modestly positive growth in the sector.

Production data has shown signs of life recently. Annual growth turned positive in South Korea, Chile and India and was less negative in Taiwan and Russia. This could signal that global economic growth is improving. However, China’s economy is bottoming only tentatively and some eurozone leading indicators have already peaked. While German industrial production could gain strongly in the first quarter, manufacturing orders look set for a decline, mainly due to lower domestic orders. Our global GDP-weighted services sector PMI has improved, notably in emerging markets, but less so in developed economies. So again, no a reason to become more optimistic on global growth.

Amid all the doubts over the shape of the US economy, the labour market has held onto its positive tone. Unfortunately, this does not say much about the risk of recession. Nevertheless, the combination of strong job growth and some slack in the labour market is positive from a cyclical perspective. There is hardly any upward pressure on wages as participation improved. In our view, the labour market does not signal an end to the US growth cycle.


We have moved part of our long position in US high-yield corporate bonds to US investment-grade. We maintained a high-yield position as the US economic outlook and monetary policy are supportive, as is a likely drop in mergers and acquisitions. Valuations are still slightly positive in our fair value model. The trimmed position fits with our overall risk reduction. Exposure to US investment-grade gives us access to the carry of US credit.

We have gone underweight commodities since we think the rally in commodities will not last and since the carry on this asset class is strongly negative at 12% per year. So even if commodities rise gradually, total returns may be negative. We have invested the proceeds in US dollar cash to prevent any currency mismatches. Investors could also opt for low-risk higher yielding assets such as short-term government debt to increase the carry of the trade.

Finally, we are now short sterling versus the US dollar. Recently, there have been cracks in the UK growth outlook and the budget perspective. Meanwhile, the UK runs a current account and trade deficit and has seen less foreign direct investment. Sterling also faces political risks.

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Please note that this article can contain technical language. For this reason, it is not recommended to readers without professional investment experience.