Global markets have adjusted to heightened risks over recent weeks. President Donald Trump's surprise threat to impose tariffs on Mexico has broadened the trade dispute beyond China. The drag from increased trade tensions is starting to show up in weaker economic data, and markets have now priced in around 100 basis points (bps) of Fed rate cuts by the end of 2020. Investors have also been contending with reports that the US government is gearing up to investigate Google, Facebook, Amazon, and Apple on antitrust grounds (source: Reuters). Meanwhile, tax cut proposals from Italian Deputy Premier Matteo Salvini increase the chances of a conflict between Italy and the European Commission over budget rules.
We took action last month to further reduce risk in our global tactical allocation. However, the recent market moves have also created opportunities, and so we make two new changes to our tactical asset allocation. We introduce an underweight to US government bonds versus cash, and add an overweight in US stocks versus international developed equities.
Underweight US government bonds versus cash Yields on the 2-, 5-, and 10-year US Treasuries have fallen by around 40 basis points over the past two weeks, to their lowest levels since late 2017. Markets now imply that the Fed will cut rates by around 70 basis points this year and 35bps next year. We find this excessive.
The chance of a rate cut has clearly risen amid rising trade tensions. However, we believe it would take a recession to provoke the magnitude of rate cuts currently being priced by the market, and this remains unlikely in our view. US unemployment at 3.6% is the lowest in decades, and rising job openings suggest there is not much slack left in the jobs market. US growth remains around trend and financial conditions are accommodative. So far, Fed Chair Jay Powell has indicated that the Fed will respond to future signs of weakness, not that a rate cut is imminent. Chicago Fed President Charles Evans, meanwhile, has said that economic data does not yet point toward the need for a cut.
As a result, we believe it is more likely that we see no Fed cut in the coming months, and think officials will take their time to adjust their communication before any move in policy. The extent of the recent move in yields and the balanced nature of Fed commentary lead us to increase our allocation to cash and deepen our underweight in US government bonds. With cash rates higher than 2-, 5-, and 10-year Treasury yields, the position also offers positive carry. We continue to recommend an overweight to long-duration Treasuries, however, because they will help us to manage downside risks if growth disappoints or trade negotiations fail to reach a timely resolution.
Overweight US equities versus international developed equities We believe that US equities are better placed than Eurozone equities in this environment of heightened risk and growth uncertainty, and express this view through an underweight to international developed equities versus the US. Historically, Eurozone stocks have only outperformed the US if the global data on new orders of manufactured goods has been strong, and when the region has been delivering comparable growth to the US. But the new orders component of the composite global purchasing managers' Index is at just 52 – barely above the 50 level that separates business expansion from contraction – and has been trending lower, and consensus estimates for the Eurozone’s GDP growth rate for the remainder of 2019 are just half of those for the US.
Despite this backdrop, Eurozone stocks have outperformed global stocks year-to-date, returning 12.2% versus 11%, as of the close of trading on 4 June. We expect Eurozone earnings per share to grow just 2.5% this year, less than the consensus forecast of 4.5%, and even this could fall further if leading indicators do not pick up soon. The region faces political headwinds in the form of Brexit and the clash between the EC and Italy over its fiscal stimulus plans. Finally the MSCI EMU index is not cheap, with a 12-month forward price-to-earnings ratio of 13.6x, versus our estimate of fair value at around 12x.
We expect the US market to be more resilient. The US Fed has more ammunition than the ECB to combat slowing growth should trade tensions escalate. And concerns about near-term regulatory risk for technology appear overdone. US antitrust investigations may take several years, and past rulings against US tech firms (albeit in Europe) did not materially affected margins or stock prices, as business models did not change fundamentally.
Should you have any comments or questions, please email ubs-cio-wm@ubs.com.