Why so cautious?

The near-term outlook doesn't match up to the risk-on message from equities.

PORTFOLIO POINT: The ongoing threat of sovereign stress in Europe, uncertainty around China and high oil prices are just some of the risks facing markets in the near term.

When we reiterate our cautious strategic risk view, the question from investors is 'why?’ The reasons are straightforward:

1) We’re sceptical that US growth can accelerate, and while more optimistic than most on China, uncertainty remains high.
2) The high oil price is already a risk to growth.
3) The crisis in Europe is far from over, with sovereign yields again moving higher.
4) Valuations are close to long run averages, with only modest upside before becoming rich.

It’s all about growth, and China is the wildcard. The latest data from Europe and China have disappointed, while it’s mixed in the US. Seasonal factors – warm US winter, China’s New Year – are compounding the data interpretation problem. However, the new optimism for the US and pessimism for China is overdone, in our view. Of the two, China is the harder call because the range of outcomes is greater, thus driving both upside and downside risks.

Hold off on the asset reallocation from bonds to equities. The rise in rates has renewed the debate about whether it’s time to reallocate out of bonds and back into equities. In 2010 during a similar debate, the substantial flows into bonds, and out of equities, was largely uninterrupted. Thus, we believe a much bigger rate move and for a much longer period is needed to actually trigger a significant reversal in asset allocation flows.

Stay cautiously positioned in the new risk regime. There are no major changes to our asset allocation after reducing risk last month. Equities, the US dollar and Treasuries have all signalled risk-on this month, suggesting risk-on correlations have changed. However, we don’t expect this risk-on regime to continue.

Global Cross-Asset Strategy: Base Case Overview

On a long-term strategic perspective, we are bearish on developed market (DM) equities, while bullish on emerging market (EM) assets. DM is in a multi-year deleveraging cycle fraught with numerous negative feedback loops, and faces a long, difficult road to economic recovery as a result. In contrast, the strong secular fundamentals for EM economies should continue.

Our base case is slowing global growth, and divergence between anaemic DM and solid EM. Our economists forecast global growth of 3.5% in 2012, with EM at 5.7% and DM at 1.2%. European recession is our base case; US and EM recession is in the bear scenario.
Sovereign risk should gradually ease as the eurozone makes progress towards a fiscal union. But the tail risk of a disorderly EU break-up remains, as the process is likely to be protracted and uneven. A more aggressive ECB under President Draghi is likely to provide a bridge to the final fiscal and institutional solution by aggressively back-stopping sovereign bonds.

The EM outlook should improve in 2H12, with increased regional differentiation. Headwinds from funding market stress should abate as the year goes on. Growth is slowing, but policy easing should improve the outlook by 2H12. China is key; a soft landing still looks likely, but growth may continue to slow in 1H12 before policy easing leads to a pick up.

Stay nimble on binary risks skewed to the downside and high volatility. With policy and politics still dominant, markets are likely to remain tactically oriented and range-bound. We expect the trading range to be smaller this year, around 10% compared to 20% last year

Asset Class Views (3-6 months)

We maintain a cautious allocation as the risk regime may change. While equities, the USD and Treasuries have all signalled risk-on this month, suggesting risk-on correlations have changed, we don’t expect this risk regime to continue. Risks are skewed to the downside, given current valuations, the potential return of sovereign stress in Europe, and high oil prices.

Credit still on top, but looking less rosy. Higher rates pose a risk, but can lead to more spread tightening if due to better growth, and that favours HY over IG. The cyclical outlook favours the US over Europe, where significant further tightening will be difficult without a decline in sovereign spreads.

Getting defensive in equities. The risk-reward is skewing to the downside because of growth concerns and valuations near fair value. EM is more attractive than DM on a medium-term view, but tactically could underperform until China starts to ease aggressively. We favour dividend-paying stocks.

Short Bunds, neutral Treasuries. We short duration in Bunds as the safe-haven bid moderates and the ECB is less dovish; additional tactical weakness is possible. Treasuries are likely to stay in a new higher range around 2.25%, until there is more clarity on growth.

Bullish on USD, bearish EUR. USD should benefit from US growth being relatively strong. The likely return of sovereign stress in Europe and rising rate differentials, however, will keep the EUR under pressure. The tactical outlook for EM FX is bearish, but strategically more positive.

More caution on commodities. Global growth uncertainty, particularly in China in 1H12, warrants caution. A stronger USD works against commodities, as does diminished prospect of more QE.

*This is an edited version of a research note from Morgan Stanley.

Gerard Minack is head of global developed market strategy at Morgan Stanley.

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