Luca Paolini, chief strategist at Pictet Asset Management, warns that there is too much “complacency” and “optimism” in the markets and he cautions trading desks to be wary of potential tail risks this quarter. He says while many investors are convinced the US economy is in line for a soft landing, he believes fears of recession have still not disappeared, or that there is no guarantee that the US Federal Reserve will cut interest rates this December.
The chief strategist walks through how he measures this market complacency and how to design a portfolio that is resilient to these potential risks. In this episode, he also looks at whether he thinks US equities are overvalued and whether we should anticipate a downturn as we come into the next cycle of quarterly earnings.
Paolini also unpacks his views on the suffering Chinese economy. He looks at the country’s long-awaited recovery and shares his thoughts on asset exposure to the region.
Interview Transcript
Jo Gallagher Welcome to Trader TV This week your insight and trading desk can prepare for the week ahead, I’m Jo Gallagher. Today I’m joined by Luca Paolini at Pictet Asset Management discuss the main topics and events leading this week. Luca welcome to the show.
Luca Paolini Thanks for having me.
Jo Gallagher As we come into the second week of October, describe your macro outlook and how you’re positioned across developed and emerging markets.
Luca Paolini We do believe the US is going into a soft landing. We believe that global growth is probably a trend. There are some areas of weakness, especially global manufacturing in Europe. Overall, the general macro outlook is positive because growth is decent. Inflation is falling. We have rate cuts coming up for Europe and in the US, and potential fiscal stimulus in China.
So we are moderately optimistic for the next 3 to 6 months. We do believe equities will deliver decent returns while for bonds it is more difficult because we do believe that the Fed is going to cut a little bit less than expected and this obviously will put a little bit of pressure on bond prices.
Jo Gallagher While central banks have begun their interest rate cutting cycles, there is still a lot of uncertainty in the market. Where do you see the biggest potential for risks?
Luca Paolini I think there is a huge level of complacency in the market. Everybody seems to believe that the US economy will go into a soft landing. Still, the Fed will be able to cut rates because inflation is going to go back to the 2% target. It is also our view. But we do believe the probability of the tail risks are a little bit higher. On one side, I think the risk of a global recession has not disappeared. We see, for example, a big decline in the manufacturing sector. We see the global PMI being very, very weak. Europe, for example, is in recession.
Even in the US, some indicators are actually on the weak side. The other risk is the opposite, that inflation will fail to decline to 2%. The US economy remains strong and in that scenario there would be no reason for the Fed to cut rates. For example, I don’t think that a rate cut in December is a done deal. We have seen pretty strong economic data in the US. The latest inflation data was also pointing upwards. The two scenarios here: The recession or a flare up of inflation are, I think, a little bit underappreciated and so there is a big level of complacency of the soft landing, fed cutting rates and I think that’s probably a little bit too optimistic in a way.
Jo Gallagher How do you measure complacency and design a portfolio that is resilient to these types of risks?
Luca Paolini But one way to look at complacency for us, is if we look at the performance of all major asset classes and sectors as well, as styles, bonds, and credit. We focus on 52 asset classes actually, and almost all of them are trading above trend. That’s to me an indication there’s too much optimism on the economy, but also too much optimism on central banks being able to deliver interest rate cuts.
The way we position ourselves. First of all, we do believe in a positive macroeconomic scenario. So we are still overweight equities, but we think you need some ideas to hedge against the tail risks and mainly we like to look at asset classes, sectors that should do better than a passive 50% equities, a 50% government portfolio in both scenarios. The obvious one is gold. Gold should do well both in a recessionary environment, but also if inflation picks up.
We have also short-term corporate bonds that should do the same. Even very defensive high-quality stocks would fit into this strategy. And finally, Japanese equities. In the end, though, because Japanese equities are cyclical, but if we add, the FX element it becomes much more defensive. So that’s how we build our portfolio. There is a core and then the edges.
Jo Gallagher Many are concerned that US equities are overvalued and that we’ll see a weak Q4 earnings cycle. Do you think traders need to be concerned for a fall off in equities momentum?
Luca Paolini Well, it is true that when you look at the historical average, the valuation of stocks, especially in tech, look pretty rich. We have a P (P/E – price to earnings) of 25 times earnings. The historical norm is around 18. But if you look relative to the macroeconomic scenario that we have in mind, we do have decent growth, falling inflation, and rate cuts. So the current valuation is pretty much in line with our estimate of value. So we are not overly concerned about valuation.
In terms of earnings, momentum has been weaker in the last few weeks in the US and especially in Europe. But we also think that the 5% expected growth in earnings for this quarter is not particularly high. We think earnings may still surprise on the upside, especially in the U.S., but not by much. Because clearly, I think we have seen a deterioration in momentum. I do believe that the upside for equities is there, but it’s not as significant as it was a few months back.
Jo Gallagher Looking more closely at China, what are your views on the Chinese recovery and your thoughts on overall asset exposure to the region?
Luca Paolini We have done [become] much more optimistic on China in the last few weeks, but only tactically, because we see from the government point of view a sense of urgency. They want to boost the economy and markets. We are still very skeptical about the medium to long term outlook for Chinese equities. But I think in the short term the flows that we see are all very encouraging and we have now in our global multi-asset fund a 3% exposure to Chinese equities and it was zero just a month ago.
But we see even more upside, I have to say, in emerging markets because we see the global economy in decent shape, inflation falling, the Fed cutting rates, all elements that tend to support emerging markets in general. And we like emerging markets equity, but also emerging market bonds mainly because of valuation. So I think we have reassessed our view on emerging markets in a much more positive tone in the last few weeks.
Jo Gallagher Thank you, Luca, for your insight and of course, you for watching this has been Trader TV This Week.
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