Presenting Pictet Asset Management’s investment convictions for the next three to six months, Frédéric Rollin was very cautious. Admittedly, he noted that January was a very strong month for equities--the MSCI World index in euros rose by 5.6%--and for bonds, which also got off to a very strong start before consolidating after the latest news.

But this does not justify the euphoria of investors. He said that investors do not seem to want to listen to the “harsh” messages delivered by the European and American central banks, which are still busy pursuing their monetary tightening. “So yes, inflation continues to fall, growth is holding up better than expected, surveys are improving and employment figures are surprisingly strong. But corporate earnings, at least in the US, are poor. And the earnings outlook is weakening.”

He believes there are two main reasons for the year-to-date rise in equity markets.

Paradoxical monetary easing

The first, “quite valid” reason is the accumulation of good news, including the resilience of the European economy and the reopening of China. It’s good news that has boosted market sentiment. Perhaps too much for Europe, says Rollin.

The second reason is that the current monetary tightening is partly neutralised by the issue of the debt ceiling in the United States, which prevents the US Treasury from borrowing freely. Banks, which used to buy sovereign bonds, are keeping their cash and investing it elsewhere, notably in equities. “And this naturally has the effect of sterilising the US Federal Reserve’s quantitative tightening.” Add to this the effects of the Bank of Japan’s current policy of monetary tightening, which is causing Japanese banks to sell off their bond holdings en masse and invest the flood of cash that they recover in part in international markets.

A paradoxical “temporary easing” that will not last for Rollin, who sees the BoJ ceasing to provide liquidity to the world. He sees the Fed and the ECB continuing to fight inflation. “For the Fed, the work is not finished. And for the ECB, it's just beginning.”

“There are no nice things to expect from the central banks. We think the market has gone a little bit too far in its optimism.”

Fragile economic environment

On the economic growth side, the “goldilocks” scenario--i.e., growth and inflation that are neither too hot nor too cold and central banks that are neither too harsh nor too soft--in which asset classes can show their full potential without risk is not for tomorrow. Rollin otherwise fears a recession, increased pressure on the economy due to monetary tightening and the loss of household purchasing power due to inflation. “We are in a fragile situation,” he insists. “We should still have a very slow economic recovery in the US in the second half of the year. A strong economic recovery and an easing monetary policy seem unlikely.” A similar scenario in Europe with even less potential growth. In short, “the message is much less positive than the one given to us by the markets since the beginning of the year.”

Margins in the shade!

For him, the investor must focus on the evolution of corporate earnings.

And the situation is not in line with market sentiment: in the US, two-thirds of companies have published results that are so far disappointing, “yet on a low-ambition basis.” “Earnings growth in Q4 2022 is -2.9% compared to -1.6% at the start of the season and +5.8% in October.”

This is the worst season since 2008, said the economist, and the slide reflects the inability of companies to pass on cost increases in a context where volumes are slowing. “The pressure on margins is getting stronger, hence the downward revisions of sales and profits today.” However, analysts remain moderately positive. “A sign that for the market, all this is temporary and that growth will soon resume. This seems to us to be a little bit illusory today. We are expecting a drop in earnings growth of around 7.5%.”

“So beware of the European and American markets, which may be a little bit excited by better-than-expected economic news and an illusion of liquidity that may not last.”

The “success” of the Chinese reopening

Rollin is, on the other hand, very positive about China, where he describes the reopening as a “success.”

This success is due to the fact that a collective immunity has been created and that the consumer is there. It’s a frustrated consumer who has accumulated cash during the confinement. Between the catch-up effect--consumption in China is currently about 10% below its potential--and natural consumption growth of around 5 to 6%, he expects growth to accelerate very strongly. “This is the opposite of what is happening in Europe and the US.”

The easing of regulatory constraints is also seen as evidence of a slightly more open Chinese economy.

As for monetary policy, which is “not specifically” accommodative, it accompanies an economy that is recovering and does not need any stimulus.

While he believes that Chinese equities are not cheap, “and even marginally a little expensive,” he is positive and plays “the idea of a strong economic recovery on valuations that are nevertheless quite close to their historical average.”

Priority to defensive stocks

Against this backdrop of caution about the economic cycle, Pictet is moving away from cyclicals in favour of defensives and growth stocks “which suffered a lot at the beginning of 2022 due to high interest rates, but which in some sectors could show quite interesting earnings growth. We think that with the current overestimation of earnings, it is in the cyclicals that the correction will take place.”

Among the sectors of particular interest is the prestige brands sector. “While the discretionary growth sector is expected to slow down, prestige brands seem to us to be particularly interesting, driven in the long term by exposure to the emerging middle class, particularly in China, which is a greater consumer of premium products and which will have greater purchasing power in the coming years.”

Prestige brands will also benefit from the development of their internet penetration initiated with the covid and the closure of boutiques. Their online sales have increased from 12% to 22% from 2019 to 2021.

As far as bonds are concerned, Rollin is “positive,” especially towards global government bonds. It’s belief based on the fact that inflation will fall.

But he still favours the best-rated credit bonds. “We have today spreads that are interesting in relation to inflation on investment grade bonds. We will be a little less positive on high yield. This is not the time to be too optimistic about this market.”

This story was first published in French on . It has been translated and edited for Delano.