Written by: John Bilton | Head of the Global Strategy Team for the Multi-Asset Solutions Group
Themes and implications from the Multi-Asset Solutions Strategy Summit
Bull markets, it is said, must climb a wall of worry, and the one we’ve been in since March 2009 seems a perfect lab test for this idea. This summer threw worries aplenty at the market. Geopolitical tension? Check. Puzzlingly low bond yields? Yep. Oil price scare? You got it. Inflation? Missing in action. But for all this, stock markets pushed on to all-time highs, and with the world economy now enjoying its best period of growth this decade we see further upside. This isn’t to ignore entirely any tail risks, or to overlook the advanced age of this business cycle, but instead to reflect that in a period of synchronized above-trend growth and loose policy, risky assets probably have room to run.
Over 2017 growth data across the globe have generally surprised positively, and the momentum in the eurozone and Japan is particularly strong. Although the level of growth remains quite modest by historical standards, its breadth is encouraging, not least as the shift in growth leadership away from the U.S. toward the rest of the world has prompted a reversal in the U.S. dollar. At the start of the year, a further surge in USD was a profound concern to many investors. It threatened not only the nascent recovery in emerging market (EM) economies and commodity markets but also raised the specter of a rapid and destructive spiral toward supply-side constraints and sharply tighter policy for the U.S. economy. Instead, the U.S. appears to be sailing serenely into late cycle, with the combination of better global growth and muted inflation providing a fair wind.
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Yet that same fair wind of subdued inflation, and the persistent easy policy that it enables, are prompting disquiet on other shores. Bond market participants—typically a more circumspect bunch than stock investors—fear that all might not be well in the economy. To be fair, the bond market has a better track record of shining the spotlight on economic issues than the stock market—so if there’s divergence between the two, we should listen to what bonds are saying, right? We’d argue not.
This year’s rally in U.S. Treasuries (USTs) was driven primarily by falling inflation and ongoing global central bank buying, not by stalling economic activity. There are secular factors—notably automation— that likely cap inflation by subduing labor costs, but many of the recent cyclical drags are transitory, and global central bank buying of bonds is slowing, not stopping. With these factors still defining the outlook for bond yields, it seems the stock market, not the bond market, is more aligned with the economic trajectory.
Given our positive view on growth, we maintain a pro-risk tilt in our asset allocation. As the U.S. economy moves into late cycle, we are naturally more attuned to any dip in higher frequency data, but currently we see little risk of recession in the next 12 months. As a result, we remain overweight (OW) stock-bond and underweight (UW) duration—albeit with slightly lower conviction in light of the failure of inflation expectations to advance alongside other macro data.
Correlation across regional indices remains low, favoring broad diversification across global equity markets. But at the margin our most favored regions remain the eurozone and Japan, ahead of the U.S. and emerging markets, with the UK our least preferred region. In bond markets we expect yields to grind higher over the fourth quarter and see U.S. Treasuries outperforming most other sovereign markets, in particular German Bunds, which look vulnerable given the robust level of eurozone growth.
Elsewhere we remain neutral on credit, real estate and commodities, and UW cash. In a distinctly mature credit cycle, returns from credit will come from carry rather than capital appreciation; nevertheless, we expect credit to outperform government bonds even if it lags stocks. Overall, we take a pro-risk stance in our portfolios but are mindful that with the economic cycle maturing, liquidity and diversification are paramount.
Overzealous policy tightening still represents the greatest threat to our pro-risk stance, but that risk seems to be receding. Indeed, with activity data positive but inflation subdued, the Federal Reserve’s (Fed’s) rates and balance sheet normalization plan seem to be subtly changing from “How much do we need to do?” to “How much can we get away with?” And as the last few years have shown us, modest growth, dovish language and easy financial conditions are the holy trinity of prolonged bull markets.
ACTIVE ALLOCATION VIEWS
These asset class views apply to a 12- to 18- month horizon. Up/down arrows indicate a positive or negative change in view since the prior quarterly Strategy Summit. These views should not be construed as a recommended portfolio. This summary of our individual asset class views indicates strength of conviction and relative preferences across a broad-based range of assets, but is independent of portfolio construction considerations.
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