While a broadening global economic recovery should continue to support markets into 2018, high asset valuations leave little cushion against unexpected market events. In this environment, bonds offer a counterweight to potential periods of equity market disruption, despite the prospect of muted returns in fixed income markets.
By Sebastien Page, David Giroux and Charles Shriver
Developed and emerging market equities could both benefit if global economic and earnings growth exceeds current expectations. US tax cuts could provide further earnings upside, while durable domestic recoveries could drive sustainable growth in Europe and Japan. Potential risks include a rise in geopolitical or trade tensions or a central bank policy misstep as interest rates and inflation both appear poised to rise.
Among developed equity markets, Europe and Japan appear more attractive than the US due to improving economic fundamentals, diminished political risk, the potential for corporate earnings growth and modestly lower valuations (see chart).
The outlook for emerging markets is more balanced. Earnings growth has improved and the near-term threat of protectionism has diminished. EM equity valuations are a bit above historic averages, although not quite as much as in developed markets. However, risks include potential declines in energy and commodity prices.
Growth stocks appear less attractive both in the US and in other global markets after their strong performance in 2017. The potential for tax cuts and deregulation in the US may support growth in value sectors, particularly financials. As a result, we have lowered our growth holdings in the US, where valuations look stretched, and increased our holdings in value sectors outside the US, where the economic growth outlook appears to have greater potential.
Potential corporate tax cuts and stronger US economic growth should favour small-cap companies given their higher marginal tax rates and greater exposure to domestic demand. However, small caps could underperform if volatility rises from current low levels. For US large caps, the strength of the dollar could pose challenges. Small caps also appear attractive in Europe and Japan, as economies there are in earlier stages of recovery and are still being boosted by loose monetary policies.
Real asset equities are an important inflation hedge in our portfolios as they have historically outperformed the broad market in inflationary periods. However, while inflation may increase from current low levels, we remain underweight to real asset equities, as we don’t anticipate a significant acceleration in inflation in 2018.
Production increases and falling costs among US shale oil continue to weigh on global energy prices, negatively affecting natural resource stocks. Likewise, China’s shift from manufacturing to consumer and service industries may depress demand for industrial metals.
While an upturn in economic growth in 2018 potentially would benefit property stocks, US real estate appears to be in the late stages of the economic cycle as fundamentals are fading and interest rates look set to rise.
Developed market bond prices are extremely high (and yields correspondingly low), held up by continued quantitative easing from the ECB, the Bank of Japan (BoJ) and, until recently, the Bank of England. Emerging market and high yield bonds potentially offer more attractive yields, but the difference in yields compared to government bonds is very low relative to history.
In developed markets, we currently favour US investment grade bonds over other regions due to more attractive valuations, less sensitivity to rising interest rates, and the potential for US dollar strength, which would hold back non-US dollar bond returns.
High yield corporate bonds appear less attractive relative to US investment grade bonds as valuations are high versus historical averages following a period of strong performance. Despite strong economic conditions and low default rates, we see less opportunity for further gains. Further declines in energy prices could pose a risk as the energy sector makes up a large part of the high-yield investment universe.
Emerging market bonds appear less attractive now following a strong performance in 2017. Yields on emerging market government bonds issued in US dollars appear especially low, and may suffer as developed market central banks withdraw liquidity from the market.
While emerging market bonds issued in local currencies are also more expensive after the 2017 rally, we believe active managers can still add value. Some currencies remain cheap and several emerging market banks are still lowering interest rates in a low-inflation environment.
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