Chief Investment Strategist and Chief Economist
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After the strong start for risk assets in 2019, we are slightly reducing our equity overweight and increasing quality fixed income.
The Citi Private Bank Global Investment Committee slightly reduced our risk asset allocations at our May 16 meeting. This reversed January’s move, where we zeroed out tactical cash holdings to increase weightings in global equities and fixed income. We have now cut our equity overweight from +2% to +1% and decreased our cash underweight from -2% to -1%. While we remain neutral or fully allocated to fixed income, we also reduced our overweight to certain local currency emerging market debt, shifting instead into short-term US Treasuries and municipal debt for US taxpayers.
Our increased allocations to both equity and fixed income in January sought to exploit the severe global market weakness at end 2018. Even with renewed volatility, year-to-date global equity returns have been about +15%. We remain overweight equities, with the expectation of returns roughly half as large over the coming year.
We estimate US EPS have risen 24% since the end of 2017, while US equity prices are roughly unchanged. The resulting sharp contraction in both US and non-US equity valuations leaves them more attractive on a long-term view.
However, returns are unlikely to be as strong and smooth as in the first four months of 2019. The second and third quarters of the year have customarily seen weaker and more volatile equity returns, especially outside of the US. Ahead of the recent deterioration in US-China trade talks, we reduced our preference for cyclical equities globally to neutral from overweight.
Since May 5, markets have moved fast but reactively to US-China tariff increases. They have appropriately priced in a greater risk of negotiations failing and trade disruption impacts spreading. In our view, investors were previously only pricing in good news. While global financial markets may still rally on a resolution of trade disputes at some point, none of the national or sectoral trade disputes begun in 2018 have been entirely resolved.
Both US and Chinese data showed greater-than-expected economic strength in the first quarter of 2019. To some extent, this strength appears misleading, and may serve to support more risk-taking among policymakers in settling disputes. If market sell-offs are needed to remind policymakers of downside risks, investor portfolios suffer. Nonetheless, US monetary policy risks – one of the main negatives for financial markets in 2018 – have been greatly reduced.
With return opportunities now slightly reduced and trade policy risks somewhat increased, we have pared back overweights in emerging Asian and Latin American equities and credit. We nevertheless see emerging Asia as offering the strongest prospective 10-year return opportunity in public markets. We reduced European small- and medium-capitalization equities from neutral to underweight. We stay slightly overweight US large-cap equities and underweight US SMID equities. We remain significantly underweight European and Japanese government bonds, but added to our large overweight in short-term US Treasuries and municipal bonds of all durations for US taxpayers.
Away from mainstream asset classes, the rise in short-dated options’ implied volatility has created an income-generating opportunity for investors willing to own particular equities at lower-priced entry points, at least for a short window of time. The “inverted” term structure of equity volatility makes for cheaper longer-term hedging opportunities.
In fixed income, many yields have fallen. However, the revival of a negative correlation between equities and US bonds is increasing the value of multi-asset class diversification. Our increased fixed-income portfolio quality may help navigate more volatile mid-year markets and potentially troubling international political developments, strengthening risk-adjusted returns