Chief Investment Strategist
November 28, 2017
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We have increased our allocation to European and emerging Asian equities to target a 12-18 month tactical return period
The Citi Private Bank Global Investment Committee (GIC) met on 15 November and raised its allocation to global equities from 2.0% to 4.0%, with US equities remaining at a full (neutral) allocation.
We increased our underweight to global fixed income from 3.0% to 4.0% and eliminated the overweight to cash and gold. These allocation changes will be implemented in portfolios in coming weeks, ideally to take advantage of the incipient weakness in equity markets.
Targeting a tactical return period of 12-18 months, the GIC raised its allocations to European equities (ex-UK) and Asian equities in both developed and emerging markets. The cyclical upturn in the world economy and structurally lower oil price is likely to favor Asian economies and markets relative to other regions.
An increasingly strong Eurozone recovery and sustained low interest rates (relative to corporate dividends) argue for a meaningfully larger overweight equity allocation. In contrast, we reduced European fixed income and a range of other developed market bond weightings to a deeper underweight.
We redeployed cash in short- to intermediate US government bonds and closely linked instruments. US Treasury bill yields are now above average long-term bond yields in other developed bond markets.
Returns for higher quality European fixed income could be slightly negative in 2018 even as ECB bond purchases continue at some level for most of the year.
In the US, we remain overweight credit, though to a slightly lesser extent, with US government bonds likely to provide a buffer in the event of a stock market correction. Of late, a very small segment of the high yield market has been impacted by M&A and tax concerns. This may be driving overstated fears in wider financial markets.
As we expected, the US dollar and domestically-focused US equities have both outperformed in recent months on the increasing probability of US tax cuts. However, these expectations are volatile.
We would suspect a lower US corporate tax rate will mean a “higher floor” for the US dollar in coming years, as one incentive to shift production abroad is eliminated. If passed, as seems probable, a US corporate tax cut will boost EPS significantly over the year in which cuts are effective.
However, US equities have climbed about 12% more than EPS since 2016, rising most strongly in two periods when tax cut prospects seemed highest. Firms with higher effective tax rates have sharply outperformed those with lower tax rates, suggesting the majority of any impact from a corporate tax cut has been priced into US equities.
Nonetheless, we would still expect net gains in US equities and economic growth in 2018, if tax cuts are passed. Apart from the US, leading indicators of global growth are stronger now than at any time since the world economy began a rebound in 2010. This suggests another year of low double-digit EPS gains in 2018. Non-US equities still trade at a near-record 35% valuation discount to the US on our preferred valuation measure. This suggests solid returns in the coming year, even with the impact of reduced central bank bond purchases and its impact on credit markets. While we do not expect equity returns to approach 2017’s (near 20% in USD), the gap between expected equity and bond performance still suggests a sizeable difference in our tactical allocations to the two asset classes.
As is always the case, a variety of political and economic risks remain notable. These include new fears of petroleum supply disruptions. However, we would expect US petroleum supplies to provide a partial buffer that did not exist in earlier periods of oil shocks.
Other trade-related disputes and security concerns remain a risk, as well as local political events. Brexit concerns keep us from overweighting UK equities. Separately, risks of a radical turn in US monetary policy appear to have fallen. Equity markets appear to be struggling with a loss of momentum and positive catalysts for short-term risk takers.
We don’t believe these are issues for longer-term investors who should take advantage of wide valuation differences across many regions to build globally diversified portfolios.