Written by: John Bilton
Themes and implications from the Multi-Asset Solutions Strategy Summit
- Global growth is set to remain above trend, but changes to U.S. trade policy and the impact of higher U.S. rates have increased the risks to our outlook. We retain our pro-risk tilt, anticipating an economic and earnings environment consistent with equity outperformance, but moderate our conviction and trim equity positioning a little.
- U.S. real yields are now positive for most maturities, so we upgrade duration to a small overweight, in part as a portfolio hedge to our equity overweight. We expect U.S. policy rates to continue steadily tightening over coming quarters, but even then monetary policy will remain accommodative and supportive for risky assets into early 2019.
- Within asset classes, we have a preference for U.S. stocks, and U.S. Treasuries over most other regions. Credit continues to be supported by strong domestic growth, but tight spreads keep us neutral. We are more cautious on emerging markets (EM) and move underweight on EM debt, where we see further headwinds from trade tensions.
IF 2017 WAS MOSTLY ABOUT HOPES, 2018 HAS ARGUABLY BEEN DEFINED MORE BY FEARS. The surge in global growth that set the tone for markets in 2017 moderated early this year, exposing worrying weaknesses in some economies. Faith in U.S. economic strength spreading around the globe is being shaken by escalating tensions over trade. And the optimism about new technology and the prospect of a surge in productivity gave way to anxiety over potential exploitation of data. Finally, fears over an imminent end to this admittedly mature economic cycle are palpable. We believe fears that the cycle is about to abruptly end are premature, and expect the period of above-trend global growth to extend into 2019. Nevertheless, we acknowledge that there is now little slack in the economy. And with policy rates set to tighten further, despite rising geopolitical tensions and weakening sentiment, we believe it is prudent to moderate risk levels and look to insulate portfolios.
From the perspective of growth alone, the outlook is still quite positive. U.S. data in particular imply meaningful domestic strength, and European growth, which dipped markedly early in 2018, is coming back strongly. Moreover, employment trends suggest that activity is brisk and that growth data could well be revised upward. The principal issue in the global economy is vulnerability in some parts of emerging markets, exacerbated by a rebound in the U.S. dollar over the summer and now prompting contagion fears and weighing on sentiment.
The elephant in the room isn’t the dollar, but trade. The early read of the ongoing trade dispute anticipated a protracted negotiation leading to an eventual deal and only a modest hit to growth. However, both the U.S. and China are digging in, and increasingly the subtext seems to be as much about advancing a trade ideology as it is about rescinding trade tariffs. As a result, both the extent and depth of any economic impact are being recalibrated. So while we continue to be constructive on the global economy over the coming quarters, it is hard to see the current surge in U.S. activity morphing into another period of coordinated global growth.
Strong data from the U.S. are, however, keeping the Federal Reserve (Fed) on track to hike every quarter into mid-2019 at least. Policy is not currently restrictive, in our view, but during 2019 we do expect fed funds rates to go beyond the neutral rate, ushering in a period of genuinely tight monetary policy. We also expect policy rhetoric in Europe to take on a more hawkish tone, contributing to a gradual but persistent tightening of financial conditions. While this probably acts pre-emptively to contain inflation risks, it equally puts inexorable upward pressure on the cost of capital for emerging market economies, exacerbating pressures from trade and the dollar.
Together these factors may leave some investors a little circumspect, but in our view above-trend global growth and reasonable earnings continue to support a positive, albeit moderated, view on risk. We have reduced our stock-bond overweight (OW) somewhat but remain constructive on equities. At the same time, we have upgraded our aggregate view on duration to a small OW, as the positive level of real yields along the curve is attractive, especially when we consider how bonds act as a portfolio diversifier. Our views on credit, commodities, real estate and cash all remain neutral, and in general our conviction levels are somewhat reduced across the board.
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Within most asset classes, our portfolios have a distinct U.S. over rest-of-world tilt. In equities, positive earnings momentum and domestic strength support our pro-U.S. view. We are constructive on Japanese equities, have downgraded emerging markets to neutral and least favor the eurozone, where the currency, not stocks, benefits most from domestic growth. In bonds, too, we favor the U.S. and expect further bear flattening in the yield curve, as long-end yields are still anchored by the persistent global bid for duration. By contrast, we expect yields on German Bunds to rise as the European Central Bank moves to bring quantitative easing to a close by December.
The changes we’ve made mark a continuation in the direction of travel for our portfolio allocation that started in the spring. We have meaningfully trimmed our risk tolerance, but, to be clear, we are still constructive on economic outcomes around the globe. It is the translation of this view to asset returns that is becoming more nuanced as we progress through late cycle, and the added disruption from trade rhetoric and gradually tighter policy clouds the return outlook. Our U.S. tilt in equities and our upgrade to duration reflect these developments, and across our portfolios we remain modestly risk-exposed through the more liquid asset markets, which we feel is prudent in a late-cycle economy.
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