Multi-Asset Outlook — Volatility rocks the boat, but is there still wind in the market’s sails?

THE RETURN OF VOLATILITY IN THE FIRST QUARTER left many investors wondering whether the years-long equity rally is starting to show cracks (Figure 1). Our take is informed by analyzing the causes of the volatility: higher inflation and higher interest rates. We expect both to continue rising modestly throughout 2018, with volatility likely to remain elevated as a result. This shouldn’t be enough to threaten the economic cycle, but it does temper our optimism about the return potential of risk assets and may warrant some reduction in portfolio risk.

Figure 1

With our base case being that the global economy can still expand nicely amid modestly higher inflation and rates, we continue to favor equities over bonds. But our somewhat more cautious view on risk assets is reflected in the specific mix of equities we favor. Specifically, we prefer US and Japanese equities relative to European and emerging market (EM) equities, and we favor value-oriented sectors, such as financials, relative to interest-rate-sensitive sectors, such as consumer staples and utilities. We think solid global growth and higher inflation, along with supply constraints, should support commodities. Within credit, we prefer bank loans and are inclined to avoid areas with particularly long duration including investment-grade and EM debt.

The outlook for inflation and interest rates: Cyclical vs structural forces

The global economic cycle is strong enough to close the output gap, generate some inflation, and pressure interest rates modestly higher (Figure 2). As the output gap closes, central banks in the US, Europe, and UK are reducing monetary accommodation. In the US, we expect the Federal Reserve (Fed) to maintain its steady and gradual approach to rate hikes, given that wage and inflation gains are still in line with its expectations. We expect the flattening of the US yield curve to abate as the Fed’s balance sheet shrinks, the global economy expands, and the European Central Bank (ECB) winds down its asset purchase program. We believe the ECB will be confident enough that inflation is nearing its target to exit its QE program by year’s end, but will pause before beginning a slow course of rate hikes in the second half of 2019. Conversely, we think the Bank of Japan (BOJ) will remain committed to its yield-curve control program for as long as possible. Finally, China, which for years has been a source of global deflationary pressure, is focused on curtailing capex and reducing supply in heavy industries, which could nudge global inflation and interest rates higher.

Figure 2

The global cycle and central bank policy points to higher interest rates ahead. That said, we only expect modest increases in inflation and interest rates because we are sympathetic to the argument that both will be capped somewhat by structural forces including technology, globalization, demographics, and high debt levels.

As central banks wind down the extraordinary accommodation of the past several years at varying speeds, currency markets may be impacted. We expect the policy moves described above, in conjunction with improving economic data in the US relative to Europe and Japan, to result in a moderate tailwind for the US dollar — particularly against the yen, which should weaken in line with interest-rate differentials.

Country and regional fundamentals

US

The US economy is bolstered by a healthy consumer and rising capital expenditures. Consumers are supported by strong labor income, a buoyant housing market, and high confidence. Manufacturing has risen and investment is expected to increase, partially on the back of tax reform and a more business-friendly regulatory landscape (Figure 3). Further, leading indicators suggest the economy should continue to expand at a solid clip, partially aided by the tailwind of recent US-dollar weakness. While the US is embarking on material fiscal expansion at a time of full employment, we don’t expect significant inflationary pressures to result through the remainder of this year.

Figure 3

Because the US economy is on the firmest footing among the major economies, we have the most confidence that US equities can perform well despite the increased volatility that could coincide with higher inflation and interest rates.

Similarly, if the Trump administration’s protectionist impulses unsettle markets but don’t escalate to a trade war, as is our base case, we would expect US equities to outperform since the US economy is relatively insulated from global dynamics. Weighing a strong economy and supportive fiscal policy against expensive valuations, we favor a moderate overweight in US equities.

Japan

The Japanese economy, while growing at a somewhat uninspiring rate, is in fine condition and recently recorded its eighth straight quarter of growth. Consumers are benefiting from a tight labor market and may finally enjoy some pickup in wages. Businesses are heavily exposed to the robust global cycle and reporting record profits. Abenomics reforms continue to align management and shareholder interests, and are having a meaningful impact on how businesses are run — as discussions between our analysts and company managements in Japan confirm.

With Japan starting from very low levels of inflation and interest rates, we wouldn’t expect local markets there to be affected much by a pickup in global rates. We think a greater worry would be a scenario (not our base case) in which the protectionist rhetoric of US President Trump turns into policies that limit Japanese exports. On balance, we favor a moderate overweight in Japanese equities given ongoing reforms, supportive monetary policy, the opportunity for alpha given low sell-side coverage, and the cheapest equity valuations in developed markets.

Europe

Europe continues to enjoy a jobs-driven expansion, and investment is picking up. However, we are starting to be somewhat less optimistic about the trajectory of growth as many leading indicators have fallen from recent highs. This is due in part to euro strength tamping down optimism. And sentiment, which was particularly high in the first quarter, is prone to a correction (Figure 4). While we were pleased to see a government form in Germany that may support some fiscal easing, we found the Italian elections a sobering reminder that populist parties continue to gain traction throughout the eurozone.

We worry that if global inflation and interest rates rise as expected, the equity market may react nervously given that it is typically sensitive to global market conditions and that economic leads have softened. The European equity market could also suffer if a trade war erupts, given that Europe is heavily exposed to global trade. Weighing all these factors, we favor a neutral stance in European equities.

Figure 4

Emerging markets

The outlook for EM is generally positive but with significant variance at the country level. China’s economy is likely to slow modestly as interest rates have risen and President Xi, his long-term power secured, will be focusing more on deleveraging and reducing pollution than on growth. We think countries focused on reform, such as Brazil and Argentina, offer more opportunities for active investors than those struggling to address structural issues, such as South Africa and Turkey. While we see opportunities at the country level, we favor a neutral stance on EM broadly given the markets’ sensitivity to global market conditions and global trade.

Credit looks challenged

Credit markets face the risk of higher yields, tight valuations, and high leverage. While the strong economic backdrop and solid interest coverage should prevent spreads from widening, it is unlikely they can tighten enough to offset losses if yields rise. We favor a moderate underweight in high yield and an underweight in investment-grade credit. We prefer bank loans due to their floating-rate structure and more attractive valuations.

We are wary about the duration of the US investment-grade index, which has lengthened to 7.5 years while spreads have tightened to nearly 100 bps. Despite our expectation of a benign growth environment, we don’t foresee spreads tightening past 50 bps, which would match the all-time tights. We think commodity prices should provide a tailwind for high yield, but fear that will be outweighed by spreads that are already under 350 bps given the small uptick in defaults this year.

Commodities appear well-positioned

A global economy that has been expanding for eight years and is starting to show signs of producing inflation should be a good backdrop for commodities. We think we are in the later stages of the global expansion, which is typically when commodities do well. Relative to other risk assets, commodities look cheap and could be poised to make up ground (Figure 5).

Figure 5

Demand for commodities should be healthy if global growth remains robust in coming quarters, as we expect. On the supply side, we think China will continue reducing capex and limiting supply as the authorities look to help heavy industry balance sheets and reduce pollution. For oil, we still foresee a US$55 – US$75 range as OPEC remains committed to supply cuts while US shale continues to improve efficiencies and limit upside potential for the price of oil.

Where do the risks lie?

We see more material risks to our outlook than we did at the end of 2017. First, while a sharp rise in inflation or interest rates is not our base case, we are attentive to the possibilities. We’re monitoring the US closely, given the potential for fiscal easing to generate higher-than-expected inflation over the next 12 – 24 months and force the Fed to hike rates more quickly. There are indications that there could be meaningful improvement in productivity in the medium term, which could help keep a lid on inflation, but thus far we haven’t seen an uptick.

Second, we are monitoring the risks posed by protectionism. President Trump has signaled his desire to impose tariffs on steel and aluminum but it remains to be seen how broadly they will be applied. More concerning is the focus on China’s intellectual property practices. While the Section 301 investigation found that China’s practices cause US businesses operating in China to lose material sums of money, it is hard to judge what actions the Trump administration ultimately may take. It is even harder to judge how other countries may respond and whether or not a trade war will ensue. Our base case is that protectionism will cause headline noise and higher volatility, but not erupt into a full-scale trade war that causes significant economic damage. We believe that the Trump administration’s ultimate goal is persuading China to address what it perceives as unfair trade practices.

Investment implications

We prefer investments in regions and sectors that may benefit from strong global growth and be relatively insulated from somewhat higher interest rates and inflation and trade restrictions. In particular, we favor:

Equities over bonds — We think the strength of the global economy and fiscal stimulus will help equities outperform bonds despite rich valuations. Moderately higher interest rates also inform our preference for value-oriented sectors, such as financials, over higher-duration sectors, such as utilities. We do not, however, anticipate a banner year for equity returns as higher inflation and protectionism could cause periods of market indigestion. We think government bonds could be challenged by higher market rates, a result of healthy growth and somewhat higher inflation.

US and Japanese equities over European and EM equities — Relative economic strength appears to be returning to the US following a period of US-dollar weakness. We are intrigued by Japan’s ongoing reforms, potential for a weaker currency, and cheapness. We are neutral on Europe because leading economic indicators have softened, the euro has risen, and the region is sensitive to market conditions and heavily exposed to global trade. We are neutral on EM at the index level for similar reasons but find opportunities at the country and company level compelling.

A moderate overweight in commodities and exposure to other inflation hedges — Given our view that the global economy has been strong enough for long enough to start producing more inflation, we think it’s a good time to revisit exposure to commodities and other potential inflation hedges, such as inflation-linked bonds. While we think we are in the latter stages of this expansion, we don’t foresee a recession in the coming quarters and think commodity demand should hold up well. On the supply side, we think China will continue to show restraint in investment partially in an effort to support commodity prices.

A continued cautious approach to credit — Long-duration credit seems vulnerable as spreads are rich, and thus we prefer to avoid investment-grade credit and EM external debt. We are less negative on high yield given its shorter duration and exposure to the US economic cycle and commodities, but prefer equities, which are less likely to be punished by higher rates. Within credit, our only overweight preference is in bank loans, which could do well with higher rates and are senior in the capital structure relative to high yield.

A close look at portfolio construction in more uncertain times — While we continue to expect equities to outperform bonds, we also believe that risks have increased. Mindful of this, we think it could be wise to consider retaining some high-quality short-duration fixed income and, if inflation increases faster than expected, leaning further into commodities and natural-resource equities.