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Barclays: our six key asset allocation calls for Q2

As the dust settles on the first quarter, Barclays reveals the areas it believes will offer the best rewards in the next six months.

Theme 1

Stay constructive until Fed tightening is a clear and present danger

In its global outlook Barclays highlights the market does not expect the Federal Reserve to raise rates at any point in the near future.

'We [felt] a modest overweight in equities (and broad risk assets) relative to fixed income remained the right allocation as long as markets believe that the start of the Fed tightening cycle was still some way off. This remains our view and little in the flow of macro news in the past three months would convince us to alter our modest pro-equity/pro-risk asset allocation.

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The lack of inflationary pressures supports Barclays view that rates will not be rising at any point soon.

'It is hard to imagine the FOMC raising rates when core PCE (Personal Consumption Expenditure) remains near 1%. We think US core PCE will pick up in H2, but we have lowered our terminal 2014 forecast to 1.7% (from above 2%).'

'Overall, while we still expect more balanced returns in equity and fixed income in 2014, the absence of any inflation threat argues for sticking with the modest overweight in equity and risk assets relative to fixed income.'

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Theme 2

There is a lot of value in risk assets, when you look outside the US

For this reason Barclays is underweight the US.

'Although we recommend underweighting the US market, where valuations look less attractive, we do not advocate an outright bearish position

'We expect economic growth to continue around 2.5% during 2014. However, with profit margins already at record levels, this is unlikely to translate into very strong profit growth.'

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Theme 3

Emerging markets are nowhere near as bad as many think

'Conventional wisdom among investors and analysts is that they [emerging markets] are historically cheap. For example, [this graph] shows that EM equity valuations according to price-to-books are near levels not seen since crisis periods such as the 2008/09 global financial crisis or the Asian crisis in the late 1990s.

'However, the prospects for EM equities may not be as challenging as they appear. While we do not see an immediate catalyst to unlock EM value, there are several positive developments that should underpin EM equities over the next quarter:

* 'In China, the government has adopted an easier stance (a weaker CNY, lower short end rates and renewed fiscal spending) and low inflation (currently 2%) should not be a constraint for further easing

* 'We expect growth to accelerate in H2 in the US and China, and the moderate recovery to continue in Europe, supporting EM via export demand

* 'The Crimea crisis is unlikely to have systemic repercussions. This is consistent with the views in our Global Macro Survey, where the majority of respondents believe it is likely to stop being a major market concern after a few weeks

* 'There is room for idiosyncratic/fundamental improvement: we are seeing better growth data and inflation falling in various EMs, notably in India.

* 'Even though we expect higher US yields by end 2014, we think a sharp move up, as in May 2013, is unlikely. Importantly, we have also pushed back the timing of any uptick in US inflation, which should leave US yields stable for longer.'

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At the same time Barclays believes emerging market debt valuations support a tactical overweight stance.

'As in the case for EM equities, we expect the external environment for EM local rates markets to improve. Notably, our near-term macro outlook includes a combination of better growth in the US and China, but only modest upside risks to US yields given the tame inflation backdrop. If we are right, we would expect this to prove a positive backdrop for higher-yielding EM fixed income.

'From a valuation standpoint, EM fixed income is a lot more attractive following the efforts of central banks (notably in the fragile five) to contain disorderly FX moves and the risk of higher inflation.'

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Theme 4

Still bullish European equity, but need to hedge EM and deflation risk

'Historically, when valuations have become either excessively cheap or expensive in Europe relative to the US, the European market has adjusted more. In other words, the US market provides a useful benchmark for European stocks. If this pattern continues, and we think it will, the valuation gap is most likely to be closed by a rally in Europe, rather than a drop in the US market.

'[However] nearly all the early-stage drivers of Japan's deflationary shock are present in the eurozone today, although in most cases the impact is likely to be less severe, at least in a region-wide assessment.

'Against this, important differences in the eurozone - fiscal consolidation, uneven monetary policy and internal devaluation suggest the deflation risks do not differ meaningfully from Japan in the mid-1990s.'

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Europe's exposure to emerging markets also casts a shadow over Barclays' conviction.

'The euro area recovery remains vulnerable to potential shocks, and we think that risks to our scenario are still skewed to the downside for 2014.

'First, risks at the global level stem mostly from the situation in EM, particularly China. A more severe slowdown in China, with potential spill-over effects in other EM countries, would have a bigger impact on Europe via the direct trade channel than on other advanced countries.

'Moreover, given the effect on commodity prices, this would amplify the risk of deflation in the euro area. The Russia-Ukraine crisis could also have adverse consequences; in particular, severe sanctions on trade and capital flows (which we think are unlikely) would endanger the European recovery, given the dependence on Russian energy and other trade and financial links.'

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Theme 6

Selling Japanese government bonds (JGBs) an increasingly good asymmetry

Barclays sees shorting JGBs as the last big asymmetry in the Japan trade.

'To date, most investors have seen the Japan macro trade as a combination of buying Japanese equities and selling the yen, with little interest in selling JGBs. While this implementation was sensible in the early stages of Abenomics, it may not be the right mix now.

'To start, the market is probably right in thinking higher inflation has reduced the chances of more Bank of Japan (BOJ) easing and likely reduced near-term upside in USD/JPY.

'But it is not clear why modest, positive inflation is not a support for Japanese equities. At the same time, if higher inflation does mean less BOJ easing, it should also mean less BOJ buying of JGBs.'

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Barclays highlights the value oppportunity in shorting JGBs.

In its latest Macro Survey Barclays asked investors what they believed to be the best implementation of the macro trade.

The results proved to be instructive in three ways.

'First, nearly one-third of investors now believe the Japan macro trade has run its course – almost certainly driven in part by the quiet, mildly disappointing performance of the trade in recent months.

'Second, investors who still believe in the Japan macro trade continue to see buying Japanese equities and selling the JPY as equally attractive implementations.

'Finally, almost no one thinks selling JGBs is an especially good way to implement the Japan trade at this juncture.'

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