U.S. and emerging market equities, primarily China, hold promise as developed markets outside the U.S. have lost their sheen, BMO Wealth Management said. The wealth advisory firm recommends moving to an overweight position on the emerging markets, while going underweight on large-caps in non-U.S. developed markets and raising a small cash position to mitigate unforeseen risks.

“This positioning provides a better risk-reward tradeoff, given that Europe faces multiple headwinds, China’s stimulus is showing signs of bolstering its economy, and the cash position slightly reduces risk after the significant year-to-date rally,” Yung-Yu Ma, chief investment strategist at BMO Wealth Management, told International Business Times.

“Currently, our overall positioning is slightly overweight U.S. equities. Of that U.S. equity position, about 75 percent is in large-caps, with the other 25 percent in mid-caps,” Yung said.

European markets have fallen out of favor among investment strategists this year, given the weakness in the bloc’s economy and the possibility of it getting caught in a trade war with the U.S.

Recent data showed euro zone manufacturing PMI fell further to 47.6 in March 2019, from 49.3 in the previous month -- the steepest pace of contraction in the manufacturing sector since April 2013.

“Much of the reduction in the recommended allocation to non-U.S. developed large-cap equities is directed toward an overweight in emerging market equities,” Yung said.

Within emerging markets, “China holds the largest sway,” Yung added, given the sheer size of its domestic economy and close ties with other emerging market economies. Even as economic data from China has been mixed, the world’s second-largest economy has been proactive in implementing measures to support its economy, including accelerated fiscal spending, reduced reserve requirements for banks and tax cuts to both consumers and corporations.

Household consumption improved in January-February, supported by recent income-tax cuts. Real retail sales grew 7.2 percent year-on-year in January, up from 6.9 percent in December 2018. Consumer price inflation eased to 1.5 percent year-on-year in February, from 1.7 percent in January.

Infrastructure investment disappointed in the first two months of the year. Housing sales fell 3.2 percent y-o-y in the first two months of the year following a 0.9 percent decline in Q4 2018, while housing starts slowed to 4.3 percent in the period, from 20.1 percent y-o-y in Q4.

Global equity markets got off to a strong start in 2019 after a sharp selloff in the fourth quarter of 2018.  Yung said increasing the cash allocation reduces the risk after a significant stock market rally. “Increasing the cash allocation, after the rebound from the Q4 selloff, takes advantage of this swift reversal while also positioning for future opportunities,” he said.

But Yung added: “Despite the sharply positive trajectory to kick-off the year, it is unlikely that 2019 will see a straight ride up in the equity markets.”

China A file photo of a photographer taking photos of the financial district of Pudong from the Bund in Shanghai on November 27, 2012. Photo: PETER PARKS/AFP/Getty Images

PREFERS MID-CAPS OVER SMALL CAPS

Yung noted that mid-cap risk has been adequately compensated in the recent decades, with higher returns than that of either large- or small-caps. The bank is neutral on small-cap stocks.

“Possible reasons why small-caps may not have the same degree of additional compensation for risk as seen with mid-caps include investors’ willingness to pay a premium price for the possibility of a “home run” small-cap investment, and also the possibility that small-cap dedicated strategies have grown too large relative to the size of that market,” he said.

Yung said this analysis reinforces BMO’s preference for mid-caps over small-caps at this stage in the economic cycle.

“Mid-caps have a more established business, better access to capital, less default risk, and lower valuations than small-caps, while still retaining some of the higher growth characteristics commonly associated with small-caps,” he said.

While the general consensus is that small-caps experience higher returns relative to large-caps due to the greater risk, Yung said only periods prior to the 1990s consistently support this idea.

“Even in the earlier time period, the additional return to small-cap stocks was concentrated in companies with the highest level of default risk based on debt levels and business volatility,” he said.

“If exposure to default risk is the primary driver of any small-cap expected outperformance, the forward-looking environment may not be particularly kind to this segment if market risk increases or the economy slows,” Yung added.

Corporate debt accumulation since 2010 has been most pronounced in small-caps, and the additional cash flow cushion to meet interest payments is far weaker in small-caps compared with large or mid-caps.

“If corporate debt concerns do come to bear, mid-caps are likely to have much less negative “tail risk” than small-caps,” Yung said.