Global Asset Allocation Views 2Q18Contributor John Bilton
- The growth outlook for 2018 remains robust, but emergence of two-sided inflation risks, and moderation in both the pace of growth and earnings revisions, lead to a mild dip of confidence in our moderately pro-risk tilt. Recent market volatility represents a repricing of tail risks and an overdue correction rather than anything more sinister.
- Policy rates are set to tighten steadily but remain accommodative and supportive for risky assets. We keep a moderate overweight to stock-bond and a small underweight to duration but close our underweight on cash, as real rates are rising. Within our equity exposure, we are placing increasing emphasis on relative value positions rather than the overall level of equity exposure, with the U.S. and emerging markets our preferred regions.
- We expect further flattening of yield curves, particularly as the global bid for duration remains supported at higher prevailing yields both by ongoing central bank buying and demand from liability driven investors. Credit still offers modestly positive returns, but tight spreads in high quality corporates lead us to downgrade U.S. investment grade credit.
If January 2018 felt much like a continuation of 2017, only more so, then the tone in markets since February could not have been more different. In short order, we were reminded that stocks can go down, as well as up; that volatility can rise, as well as fall; and that inflation can surprise positively, as well as negatively. We do not believe that recent market jitters are anything more sinister than a repricing of two-sided economic risks. We remain constructive and expect stocks to outperform bonds in 2018. But the re-emergence of two-sided inflation risk in some regions and the moderation in certain higher frequency growth indicators suggest we need to subtly shift how we express our constructive view as the economy moves through late cycle.
We expect that the pattern of coordinated, above-trend global growth we’ve enjoyed for the past few quarters will extend throughout 2018. Yet the initial acceleration in growth is fading and the second derivative—how quickly the rate of growth is rising—is slowing. This may seem contradictory, but a prolonged period of stable, above-trend growth is far from unprecedented; the subtlety is that the scope for further upside surprise is diminishing. Stocks should perform well in this environment, but the surge in global earnings expectations may be moderating, ushering in a phase where consistent delivery rather than the promise of earnings is most rewarded.
The re-emergence of two-sided inflation risks in regions like the U.S., Canada and the UK reinforces our outlook. Over the last year, the economic environment was characterized by a broad-based pickup in growth with benign inflation; we may be transitioning to a broad-based pickup in inflation with a benign growth backdrop. In nominal terms, the quantum of overall growth is similar. But while an increase in real growth gives a shot in the arm to earnings generally, normalization of inflation hands an earnings advantage to regions and firms with pricing power and superior cost controls. We see little risk of runaway inflation—particularly with eurozone and Japanese core inflation still subdued—but we do see global inflation steadily rising.
There’s an irony that a central aim of quantitative easing (QE) was to normalize inflation, and now that it’s finally happened, investors are concerned that central banks are behind the curve. A case of being careful what you wish for, perhaps, but the reality is rather more mundane—simply, investors are having to dust off the playbook on trading a sustained rate hiking cycle for the first time in a decade. Investors are also calibrating how far and how fast rates can rise, as well as adjusting for the uncertainty of both a new Federal Reserve (Fed) chairman and the divergence of policy around the globe. We expect 25 basis points (bps) hikes to U.S. rates roughly quarterly through to the end of 2019 —a pace that markets should take in their stride.
In late-cycle environments, stocks tend to perform well until monetary policy becomes genuinely restrictive—which is some ways off. Nevertheless, two-sided inflation risk plus policy uncertainty will likely translate to a modestly higher level of market volatility. In this environment, earnings growth rather than multiple expansion is set to be the key driver of equity returns. We maintain our moderate overweight to equities, but with a little less conviction and with an expectation of more regional divergence. Markets with pricing power, solid earnings delivery and pro-cyclical gearing should outperform regions with currency headwinds, margin vulnerability or an overly defensive sector mix. Last year our preference for a broadly diversified global equity exposure served us well, but in 2018 we anticipate an increasing emphasis on relative value equity positions. Within our equity overweight, our order of regional preference is the U.S. and emerging markets ahead of Japan, the euro area and the UK, which are ahead of Canada and Australia.
We expect bond yields to increase in 2018 as U.S. policy rates are tightened. But ongoing central bank bond buying in Europe and Japan will put a cap on how far bond yields can rise, resulting in flatter U.S. yield curves. We maintain our small underweight on duration but close our underweight on cash, as real yields are increasing and we are becoming less inclined to deploy leverage in our multi-asset portfolios. Credit markets in aggregate should deliver modestly positive returns this year, but we are concerned that spreads have tightened unsustainably in some higher grade credits and so introduce a small underweight to U.S. investment grade (IG), even though we stay neutral on credit overall.
In sum, our allocation represents a continued pro-risk tilt, but the greater emphasis on relative value positions in equities reflects the maturing cycle, two-sided risk in inflation and greater policy uncertainty. To be clear, the Fed has not yet “taken away the punch bowl,” nor do we expect it to this year; and while we believe markets can withstand higher rates, investors will be sensitive to any data that might accelerate the pace of rate hikes.
KEY THEMES AND THEIR IMPLICATIONS
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