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4Q18 Multi-Asset Outlook: How Late in the Cycle Are We?

October 2018
By Nanette Abuhoff Jacobson

Reduced growth and rising inflation are both trends that are likely to continue until this bull market finally breathes its last breath.



It would be nice if we could mark the end of the business cycle on a calendar and plan accordingly, but the best we can do is look for clues in the market and economic data. My conclusion: The pace of global growth has slowed and inflation has risen—trends that are likely to continue and are consistent with late-cycle dynamics. I think the outlook is solid enough to support a case for equities over bonds, but not higher beta1 equity markets in Europe, Japan, and emerging markets. Within equities, I would consider the US over other markets and value over growth. I would also consider focusing on smaller, domestically oriented companies. I think commodities may do well given still-solid global growth, constrained supply, and rising inflation. Within credit, I would consider high yield and bank loans, and avoiding long-duration2 sectors such as investment-grade corporates.


Global growth: Enough in the tank to lift inflation and rates modestly

The global economy appears to be shifting to a lower gear, yet I think growth should be sufficient to continue reducing excess capacity and lifting inflation and interest rates. Developed market monetary policy has become less supportive (FIGURE 1), but I expect central banks to tighten policy cautiously and to varying degrees—and not enough to choke off growth.

I think the US Federal Reserve (Fed) will maintain its gradual pace of rate hikes this year but hike less in 2019 than its forecast suggests as fiscal stimulus fades, concerns about the flat yield curve grow, and rates potentially bump up against the neutral rate. I expect the Fed to tolerate, and even welcome, a period of higher-than-target inflation after many years of missing its symmetric target on the downside. I continue to expect the European Central Bank to wind down its asset-purchase program by the end of 2018. While growth in Europe has disappointed, it is still likely strong enough that such extraordinary stimulus is no longer necessary.

However, I do not expect any rate hikes in Europe until after the summer of 2019. I think the Bank of Japan will remain committed to its accommodative stance despite its recent decision to widen the band in which the yield on the 10-year Japanese government bond can trade. In China, the authorities seem intent on further reducing supply in heavy industries, which I think could lift global inflation and rates at the margin.

Figure 1: Global money supply is slowing
GDP-weighted M1 money supply, year-over-year % change*

M1 is the money supply that includes physical currency and coin, demand deposits, travelers checks, other checkable deposits and negotiable order of withdrawal (NOW) accounts. | *Includes US, Europe, Japan, and China | Sources: Bloomberg, Wellington Management | Chart data: December 1996 – August 2018

While my cyclical leads point to higher inflation and interest rates in all major regions, I think increases will be limited given deflationary structural forces, including technology, demographics, and globalization. I believe the US-dollar strength we’ve been anticipating this year as the US economy outperforms has largely played out. While I expect continued US economic outperformance, I expect the growth gap between the US and the rest of the world to narrow and the US dollar’s strength to moderate.


Global growth: Enough in the tank to lift inflation and rates modestly

I expect the pace of US economic growth to slow modestly but remain higher than other developed economies. While the impact of tax reform is likely to start petering out, US consumers should be buoyed by a tight job market and higher wages (FIGURE 2). Despite getting dinged by trade concerns, capital expenditure data remains robust and I think investment could add to growth in coming quarters. I am mindful that poorly timed fiscal stimulus may generate too much inflationary pressure and am closely watching inflation dynamics. I anticipate more protectionism, but believe the impact on overall growth should be manageable. If global trade were to slow as a result of US policy changes, I would still expect equity investors to prefer US assets, as the US has a relatively insulated economy and stock market.

Figure 2: Tight US labor markets leading to higher wages

Skilled labor shortages is the % of respondents signaling that quality of labor is their single most important problem. Sources: US Bureau of Labor Statistics, NFIB,4 Haver | Chart data: June 1994 – June 2018

Given my more positive outlook on US growth relative to other
developed economies, I see more favorable risk/reward potential in US equities than their higher-beta developed market peers. Valuations are admittedly not as attractive in the US as in some other markets, but I view this as less of a concern over the 6-12 month horizon that is my focus here.



Europe’s economy disappointed versus consensus expectations earlier this year by not attaining the levels of growth suggested by many leading indicators (FIGURE 3). Although business cycle indicators currently point to a further contraction in growth, I am hopeful that the underpinnings of the European consumer, such as real incomes and the credit channel, are healthy and should prevent much more slowing ahead. Although I expect the decline in the pace of growth to moderate, my outlook for European equities is tempered by lingering concerns about the economy and the high sensitivity of European companies to the global cycle.

Figure 3: European PMI* no longer as bullish for Gross Domestic Product (GDP)

*PMI (Purchasing manager’s index) is an indicator of the economic health of the manufacturing sector. A reading above 50 signals economic expansion; below 50 signals contraction. Sources: Bloomberg, Markit, Wellington Management | Chart data: PMI data (monthly): July 1998 – August 2018. GDP data (quarterly): 3Q1998 – 2Q2018



Economically speaking, Japan is in decent condition. Consumers are enjoying a historically tight labor market, while company margins are buoyant and cash balances are high. However, I am increasingly concerned about Japanese stocks’ sensitivity to the global cycle and the fact that with every market hiccup, the yen appreciates and stocks suffer. Given the moderation in global growth that I expect and a host of geopolitical and economic risks, I have downgraded my view on Japanese equities from moderately bullish to neutral.


Emerging markets

I continue to hold a neutral view on emerging-market (EM) equities despite the upside potential of recent policy loosening by China to combat trade worries. My base case is that China’s economy slows in response to a structural deleveraging campaign, but I am monitoring how the economy responds to the policy loosening and a weaker currency.

More broadly, I worry that EMs are highly sensitive to global market conditions and that many large countries, such as Brazil, Argentina,Turkey, and South Africa, face idiosyncratic headwinds that could be exacerbated by higher developed market interest rates and a stronger US dollar. Together, these country-specific risks dent the prospects for EM equities, and so I maintain our neutral stance over our 6–12 month time frame.

Looking out over the next several years, however, I am cognizant that EMs have cheaper valuations and the potential for better long-term growth than developed markets.


Cautious on credit

The outlook for credit performance remains challenged given my expectation of higher yields, tight valuations, and higher leverage.Taking these factors into account, along with the potential for higher interest rates, I think the investment-grade corporate sector, with its seven-plus year average duration, is particularly vulnerable. I find better value in bank loans due to their floating-rate nature and attractive yields.Despite rich spreads,5 I have upgraded my view on high yield one notch from moderately bearish to neutral as I favor the US-oriented revenue sources of high-yield companies.

One negative that stands out in the credit market is that leverage is higher today and covenants are weaker—issues that I trace to the investment-grade corporate market, where spreads tightened back to rich levels in the third quarter and leverage has grown to levels comparable to the high-yield market. While wider spreads in EM external debt (USD-denominated) piqued my interest, I am still comfortable with my moderately bearish stance because many of the largest issuers face steep country-specific challenges and current account deficits leave them vulnerable to external shocks.


Risks include liquidity and politics

I divide the market risks into two categories: those related to global liquidity and those related to politics. In the first category, a sharp rise in inflation could induce more or larger rate hikes by the Fed, which would likely hurt risk markets, especially in countries, companies, and sectors with high leverage and liquidity needs. But as noted, I expect inflation to stay relatively low and believe the Fed will accept somewhat higher inflation and refrain from additional rate hikes.

Among political risks, trade issues, US mid-term elections, an Italian budget battle, and Brexit negotiations are all on the horizon and share a common theme of populism. Rising trade tensions remain the number one risk for the global economy in our view. Right now, the direct impact on growth and sentiment seems to be minimal and our base case remains that the Trump administration would soften its rhetoric if trade concerns had a material impact on economic growth. However, if tariff s expand, the negative ripple effects of higher input prices, higher consumer prices, and disrupted supply chains could damage today’s elevated business and consumer confidence and the global cycle.

Investment Implications 

Equities over bonds — While I expect margins to be somewhat lower in the face of higher input costs, I think growth remains strong enough to consider equities over bonds. I think bond yields should rise in response to higher inflation and curtailed quantitative easing. This leads to my view that value-oriented sectors may be more attractive than interest-rate-sensitive sectors.

US equities over other regions — I think the US stands out as the strongest economy and will likely continue to benefit from the fiscal tailwinds of lower taxes and deregulation, as well as the country’s relatively low revenue exposure to the rest of the world. Europe, Japan, and EMs are more exposed to a slowing global cycle and continued trade tensions.

Commodities and other inflation hedges — Burgeoning inflation may pressure portfolios that are not adequately protected. I would consider Treasury inflation protected securities (TIPS), natural resource equities, and commodities, which should benefit from a reduction in supply.

Selective on credit — I think investment-grade corporates are vulnerable since spreads may not be wide enough to compensate for duration risk and increased leverage in the sector. I am less negative on high yield given its shorter duration, its exposure to the US economic cycle and commodities, and positive structural changes in the market.

High-quality fixed income — Slowing growth and higher inflation may be signs that we are late cycle. Therefore, I would consider retaining high-quality fixed income, though shorter in duration than the index.

Change is from previous quarter. Views expressed have a 6 − 12 month horizon and are those of the authors. Views are as of September 2018, are based on available information, and are subject to change with-out notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an off er to purchase shares or
other securities.

Managing Director and Multi-Asset Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds.

1 Beta is a measure of risk that indicates the price sensitivity of a security or a portfolio relative to a specified market index.
2 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.
3 A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. A flat yield curve is a yield curve in which there is little difference between short-term and long-term rates for bonds of the same credit quality.

4 The National Federation of Independent Business is the largest small business association in the US.
5 A spread is the difference between the bid and the ask price of a security or asset.

Important Risks: Investing involves risk, including the possible loss of principal. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political and economic developments. These risks may be greater for investments in emerging markets. • Mid-cap securities can have greater risks and volatility than large-cap securities. • Commodity investments are subject to additional risks.

• Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Loans can be difficult to value and highly illiquid; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks. • The value of inflation-protected securities (IPS) generally fluctuates with changes in real interest rates, and the market for IPS 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.

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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