Global Asset Allocation Views 3Q18Contributor John Bilton
- A challenging first half for asset markets doesn’t obfuscate the positive global growth outlook for 2018. While it is true that the pace of growth has moderated it remains above trend, and with both expectations and positioning less stretched we see scope for better asset returns in the second half.
- Investors’ tail risk fears have shifted from concern about inflation overshooting and triggering more rapid rate hikes, to growth undershooting and crimping earnings. Against this backdrop, bonds are an effective portfolio hedge, and with real yields moving higher duration is less costly to hold in portfolios.
- We keep a moderate overweight to equities with a preference for U.S. and emerging market stocks; we close our duration underweight and keep a neutral stance on credit and cash. At the margin the moderation in the pace of global growth leaves us a touch less convicted on our pro-risk tilt, but our increased appetite to hold bonds within portfolios mitigates our risk to a good degree.
Based on the market narrative from early January, 2018 hasn’t exactly gone according to script thus far. It was all so clear at the start of the year: Coordinated global growth and booming earnings would drive bumper first-half gains before rising rates eventually caught up and spoiled the party, leading to a more challenging second half. But as of the end of May, total year-to-date returns for world equities were essentially flat, with the U.S. up 2% and the rest of the world down 2%. Meanwhile, U.S. 10-year yields rose 50 basis points (bps) but German 10-year yields were essentially unchanged. It’s almost like the second half of the year happened six months early.
So what went wrong? While growth has moderated, it is still above trend, and earnings have been good; certainly, geopolitical anxiety and risks to global trade have ticked up, but the macro environment is generally supportive of taking risk. In our view, the tricky market dynamics in the first half of the year were driven partly by the unwinding of frothy sentiment and stretched positioning. For the rest of 2018, the growth outlook is solid, so with policy still accommodative and investors’ expectations reset to more reasonable levels we see scope for returns to improve in the second half. Nevertheless, if the early part of the year did nothing else, it should remind us that late-cycle economies give little quarter to complacency and still less to exuberance.
In the second half of 2018, we expect stable, above-trend growth, balanced inflation risks and gradual removal of central bank accommodation. At the same time, concerns about trade, geopolitics and the simple length of this expansion are likely to occasionally bubble up. Yet a pragmatic recognition of risks to a broadly constructive base case is probably a healthier backdrop for asset markets than the flirtation with exuberance we saw in January. Recession risk is still quite low, particularly considering the length of the U.S. expansion, and historically it is unusual for stocks to underdeliver for a prolonged period when the economy is expanding. With expectations and sentiment now reset to a more reasonable level, equity markets should be better able to respond well to favorable data—albeit probably at a more measured pace than in the second half of 2017.
Another subtle shift in the investing calculus also occurred over the first half of the year as investors went from being most fearful about inflation overshooting to being more concerned about growth undershooting. While a pickup in U.S. inflation data may have catalyzed the correction in February, threats to growth—oil prices, dollar strength, eurozone political angst, etc.—now seem to worry investors rather more than inflation. To be clear, these are tail risks, but as investors shift the focus of their fears from inflation risk to growth risks, bonds become a more compelling part of the portfolio.
At the margin, this gives us latitude to maintain a constructive view in portfolios while still acknowledging that tail risks have ticked up—we are still moderately pro-risk, but our conviction is a touch lower. With higher U.S. Treasury yields better reflecting inflation risks, we can balance our portfolio risk with a little more duration rather than simply trimming equity overweights at a time when we believe stock markets are regaining their poise. We maintain our moderate overweight (OW) to stocks but close our duration underweight (UW), and stay neutral on credit and cash.
The U.S. and emerging markets (EM) are our preferred equity markets. We see further earnings upside to U.S. stocks, as well as a favorable sector exposure to technology. EM equities faced headwinds from a dollar rebound in the first half, but as this burst of strength fades we expect the superior pace of growth in many EM economies to drive earnings upgrades. By contrast, we see eurozone equities struggling a little in the second half as the 2017 surge in European growth moderates and political risks present an unwelcome distraction.
In sovereign fixed income, we expect higher yielding countries like the U.S. and Australia to outperform German Bunds and Canada. UK Gilts could also perform quite well, despite their modest yields, as Brexit uncertainty weighs on the economy. In credit, corporate leverage is a key factor to monitor, but with recession risks low we don’t see it as a binding constraint just yet and expect low but positive returns from corporate bonds.
Asset returns in the second half of 2018 should be an improvement on the first half, but there is a growing sensitivity to any threat to economic growth. The return of U.S. short-end rates to positive territory means a higher hurdle for deploying capital to riskier assets; but equally the higher yields on bonds also means that diversifying pro-risk positions in portfolios is less costly. U.S. yields at around 3% do not seem to be the constraint on equity returns that was feared, and indeed may—for the time being—even grant investors a level of comfort in keeping a risk-on tilt as the economy moves deeper into late cycle.
KEY THEMES AND THEIR IMPLICATIONS
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