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2018 Multi-Asset Outlook: Can the Party Go On?

December 2017
By Nanette Abuhoff Jacobson

As central banks remove their accommodative policies, many are wondering if the party can continue with less punch in the bowl.

 


 

It’s no secret: Despite a favorable economic environment, investors are worried about valuations and complacency as central banks move forward with the removal of unprecedented monetary accommodation. While this sounds like the end of the party, my take is that central banks will be quite gradual in their withdrawal of support and that the economy is strong enough to withstand a bit less punch in the bowl. I expect this combination to result in moderately higher interest rates and to support risk assets (such as equities, commodities, high-yield bonds, real estate, and currencies), and, therefore, I suggest being more bold than cautious in the coming year.

 

Figure 1
Global synchronized expansion
Composite purchasing managers’ indexes (PMI)1
January 2010 – October 2017

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Sources: Haver Analytics, IHS Markit, Wellington Management

 

Specifically, I prefer equities over bonds, and within equities I prefer Europe and Japan relative to the US. While I am positive on the long- term outlook for technology, I expect profit-taking after the sector’s spectacular run in 2017. I favor rotating into value sectors, such as financials, and avoiding sectors that are particularly interest-rate sensitive, such as consumer staples and utilities. I think emerging market (EM) equities and commodities should benefit from solid global demand and a stable China. I expect disruptive forces to continue creating individual winners and losers within many sectors, a trend that has provided a more attractive environment for active management (FIGURE 2).

 

Figure 2
Low, but increasing, dispersion3 within most sectors
Dispersion (%)

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Data is calculated monthly starting in January 1994. Monthly return dispersion across all sector returns for each index is calculated for each of the past six months, then the average of these six data points is taken. Sources: MSCI, Wellington Management.

 

Even moderately higher rates will be a headwind for fixed income, especially in Europe, where I expect core government bonds to underperform. While supported somewhat by fundamentals and technicals, credit spreads are very tight, and as a result I expect total returns to be challenged in a higher-rate environment. This poses a greater risk for longer-duration credit such as investment-grade corporates and EM dollar-denominated debt.

 

Higher rates are coming, but the global economy can handle it

In my view, global growth is robust enough to shrink the output gap, lift anemic inflationary pressures, and produce moderately higher interest rates. Central banks in the US, Europe, and the UK are reducing monetary accommodation. In the US, I believe the market is not pricing in enough rate hikes relative to the Federal Reserve’s (Fed) current forecasts, which do not yet account for fiscal easing. But I anticipate a moderate lift in US nominal yields driven by a moderate rise in inflation and real gross domestic product (GDP).3 I believe that US productivity is improving and, along with forces of technology, globalization, and demographics, putting downward structural pressure on inflation and, thus, interest rates. I don’t expect the yield curve to flatten further as rate hikes will lift short-term rates while inflation and a normalizing term premium post-quantitative easing (QE) will pressure the long end higher.

Over the next year, I think the European Central Bank’s (ECB) path is toward tightening and that German yields are most vulnerable to an increase. The Bank of Japan (BOJ) is deeply committed to its policy of yield-curve control, which is starkly different from that of the Fed or the ECB. Finally, China, which for years has been a source of global deflationary pressure, is now focused on curtailing capital expenditure and reducing supply in heavy industries, which could nudge inflation and rates higher.

As central banks move toward QE exit at varying speeds in the coming year, currency markets will feel the effects. I expect the policy moves described above will result in a moderate tailwind for the dollar versus the euro and to pressure the yen lower.

 

Country and regional fundamentals

Europe
Europe is the fastest-growing economy among major developed markets and a host of leading indicators suggest it will remain so. Consumer and business confidence are at multi-year highs and bank lending is recovering. The expansion has been jobs driven and consumer oriented, which reduces Europe’s sensitivity to the global cycle. Following the euro’s strong appreciation last summer, I have a more sanguine view going forward and don’t expect the currency to have a material impact on economic performance in the coming quarters. I anticipate modestly looser fiscal policy in 2018 as austerity is dialed back and, as noted, think the ECB will remain supportive. Given a positive economic backdrop, supportive policy, and moderately attractive valuations, I favor an overweight position in European equities. I don’t include UK exposure in this view, as I think real wages could be pinched and investment spending could fall in anticipation of Brexit. However, I expect any Brexit-induced slowdown to be contained to the UK.

Japan
The third quarter of 2017 marked Japan’s seventh consecutive quarter of economic growth. I expect the trend of solid if unspectacular growth to continue. Business confidence is improving on the back of record profits and increasing cash flow. Consumers have been buoyed by a strong labor market that has absorbed a steady increase in female participation (FIGURE 3). This has improved labor income but also played a role in keeping wages stagnant. Anemic wage growth and inflation provide cover for the BOJ to continue its aggressive easing policies. Prime Minister Shinzō Abe has regained his political footing and is poised to push forward with Abenomics reforms and potentially expansive fiscal policy. In light of very supportive policies, cheap valuations, and an economy that is healthier than many market participants acknowledge, I favor an overweight position in Japanese equities.

 

Figure 3
Structural reform in Japan: Women join the workforce
Female labor force participation, 1990 – 2016 (%)

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Source: Organisation for Economic Co-operation and Development (OECD)

 

US
The US economy continues to expand at a steady clip, and I think growth in 2018 could be bolstered by an expansionary fiscal stance. Consumer confidence is high, the job market is strong, wage gains are reasonable, and home prices are rising. Business investment is starting to rebound and capex intentions are robust. Against this backdrop, some combination of tax relief and hurricane-recovery spending is likely to add to growth in 2018. Further, deregulation is likely to be a tailwind for investment spending and growth. Strong economic fundamentals and supportive policy are partially offset by high valuations (FIGURE 4), so I continue to favor a moderate overweight in US equities.


Figure 4
Equity valuations favor non-US markets
20-year percentile rankings, November 2017

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Sources: MSCI, Datastream, Wellington Management

 

China and other emerging markets

Having centralized power and elevated his position during the 19th Party Congress, President Xi Jinping can prioritize curtailing supply in industries, such as coal, steel, and aluminum to help reduce excess capacity and pollution. I also expect Xi to focus on reducing leverage in the financial system by tightening credit. This, in combination with signs of weakening in the property market, should slow the economy. Given high consumer confidence engendered by a strong job market and high home prices, however, the slowdown should be modest.

Looking at other EMs, I see a diverse set of economic dynamics and favor both equities and local debt in countries where growth is expanding and inflation is falling, including Russia and Brazil. Within equities, I see opportunities in India and China. Given sound economic fundamentals, mixed policy, and relatively attractive valuations, I favor a moderate overweight in EMs.

A mixed picture for credit in 2018

On the positive side for credit markets, there is a healthy economic backdrop, ample interest coverage for debt service, and strong demand. On the negative side, there is the risk of higher yields, high leverage, and rich valuations. On balance, I favor a neutral stance in high yield and a moderate underweight in investment-grade credit. I also favor bank loans for their floating-rate structure and attractive valuations.

It may seem counterintuitive to be defensive on credit when I am bullish on equities. But while equities and credit are supported by many of the same fundamental factors, credit is exposed to rich valuations and higher interest rates. Conversely, equities tend to do well when growth drives rates higher, which I expect to happen, and the potential for earnings expansion means rich valuations are less threatening.

Further, credit and equity performance can diverge if creditors perceive that shareholders are benefiting from debt-financed activity at their expense. FIGURE 5 shows that investment-grade debt levels (BBB) are approaching those of high-yield companies (BB) as a result of debt-financed enhancements to shareholder value.

 

Figure 5
Higher credit risk in high grade?

MFGS_121517_5

Source: JPMorgan

What about the risks?

For the global economy, inflation is the wild card. While not my base case, an unexpected rise in inflation could force central banks’ hands toward more aggressive tightening and raise the risk of recession. If the US yield curve flattens further, it would signal tighter financial conditions.

Global trade is another risk for markets. The US could set off a stagflationary dynamic if it enacts severe trade restrictions. Geopolitics are also a concern, but I think any market disruptions are likely to be temporary.

While I think the risk of a recession is low, the risk of a market correction is higher. Rich valuations leave less room for markets to absorb an adverse event, and, thus, a notable pullback in risk assets seems plausible over the course of the coming year. However, I do not expect a correction that leads to recession given that global economic fundamentals are doing well.

Investment Implications:

I see opportunities in regions and sectors that may benefit from solid fundamentals and somewhat higher interest rates and inflation. In particular, I favor:

  • Equities over bonds — I think positive global economic momentum along with some fiscal stimulus will help power equities higher despite rich valuations. I also think moderately higher interest rates will help equities outperform bonds. Higher interest rates, driven by some growth and inflation, will challenge government bonds though I see value in inflation-linked bonds.
  • European and Japanese equities over US equities — Fundamentals are good in all three regions, but I see more earnings upside in Europe and better valuations in Japan, giving us a bullish view on these two regions. In Europe, I favor financials, domestically oriented companies, and the small- and mid-cap sectors. In Japan, I find opportunities across the cap structure. I favor a moderate overweight in the US and prefer sectors that have historically held up better when interest rates rise (e.g., energy and financials) to those that have struggled (e.g., utilities and consumer staples).
  • Moderate overweights in EM equities and commodities — China’s real growth is likely to slow somewhat given the property market’s turn and rising inflation from input prices and wages. A stronger US dollar could also be a headwind for EM and commodities. Still, global growth, strong commodity prices, relatively inexpensive valuations, and improving fundamentals in many countries help explain why I favor moderate overweights in EMs. I expect that commodity prices will be supported by the Chinese government’s supply restrictions.
  • A cautious approach to credit — Long-duration credit seems particularly vulnerable given rich spreads, and, thus, I prefer avoiding exposure in investment-grade corporates and EM external debt. I favor shorter-duration bank loans, EM local debt, high yield, and financials. I also like US housing-related assets, which are supported by favorable supply/demand dynamics and rising household formations. In my view, municipal bonds offer superior “value for risk” and diversification relative to investment-grade corporates given lower default risk and insulation from shareholder-friendly activity.
  • Portfolio construction in pursuit of risk mitigation — While my base case is a benign economic and policy environment in which risk assets could outperform, I think it’s an appropriate time to revisit portfolios to ensure they include assets that could potentially generate positive returns if my base case turns out to be wrong — i.e., we get a more inflationary or recessionary environment than expected. In my view, high-quality government bonds will still be negatively correlated to equities in a risk-off event. Natural-resource equities or commodities could help in the inflationary case. Gold-related assets may help mitigate downside from currency devaluation, geopolitical risk, or stagflation. 
Managing Director and Multi-Asset Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds.

1 Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing sector. A reading above 50 signals economic expansion; below
50 signals contraction. Past performance is not a guarantee of future results. Indices are unmanaged and not available for direct investment.
2 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.
3 Dispersion is a statistical term describing the size of the range of values expected for a particular variable.
4 Gross Domestic Product (GDP) is the monetary value of all the finished goods
and services produced within a country’s borders in a specific time period.
5 Capital expenditure, or capex, are funds used by a company to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment.
6 Price/Book is the ratio of a stock’s price to its book value per share.
7 EBITDA (Earnings Before Interest, Taxes, Deprecition, and Amoritization) is a measure of a company’s earning power from ongoing operations, equal to earnings before deduction of interest payments, income taxes, depreciation, and amortization. EBITDA excludes income and expenditure from unusual, non-recurring or discontinued activities.

All investments are subject to risk, including the possible loss of principal. Foreign investments can be riskier and more volatile than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as political and economic developments in foreign countries and regions (e.g., “Brexit”). These risks are generally greater for investments in emerging markets. Small- and mid-cap securities can have greater risk and volatility than large-cap securities.

Fixed Income risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall; these risks are currently heightened because interest rates are at, or near, historical lows. Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Bank loans can be difficult to value and highly illiquid; they are subject to credit risk and risks of bankruptcy and insolvency. Municipal securities may be adversely impacted by state/local, political, economic, or market conditions. Investors may be subject to the federal Alternative Minimum Tax as well as state and local income taxes. Capital gains, if any, are taxable. The value of inflation-protected securities generally fluctuates with changes in real interest rates, and the market for these securities may be less developed or liquid, and more volatile, than other securities markets. U.S. Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. Commodity investments are subject to additional risks. Diversification does not ensure a profit or protect against a loss in a declining market.

The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

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