2017 Global Market Outlook Q4 update: Momentum vs. asymmetry
It’s time for the final installment of our 2017 global market outlook: our forecast for the fourth quarter of the year. At this juncture, we find that developed economies are in the “sweet-spot” of moderately above-trend growth, continuing low inflation and easy monetary policy (or in the case of the U.S. Federal Reserve, very gradual tightening). Since our mid-year update, equity markets have drifted higher, corporate credit and real assets have gained and government bonds have rallied. As a result, we see the global market as offering a supportive environment for just about every part of a portfolio.
Global equities: Cycle, value and sentiment
Two words that keep recurring in our strategist team discussions are momentum and asymmetry. A benign economic environment can see markets trend higher. We capture this in the sentiment part of our cycle, value and sentiment (CVS) investment decision-making process.
Starting first with global equities, our cycle scores are mostly neutral to slightly positive. We view Europe, Japan and emerging markets as positive, but remain neutral on the U.S., due to the current momentum-driven rally. Overall, we’re sticking to our “buy the dips and sell the rallies” credo—a belief we’ve held about the market environment since the start of the year.
It’s the value part of our CVS process that creates asymmetry concerns. Specifically, when considering U.S. equities, the elevated level of the cyclically adjusted price earnings ratio (CAPE) makes us nervous about asymmetry—that the downside for S&P 500® Index returns is larger than the upside. Thanks to Professor Robert Shiller, we have a history of the S&P 500 CAPE back to 1880. It currently stands at just over 30-times trend earnings, a level reached only twice before; during the tech bubble of the late 1990s and in the 1929 market boom.
A high CAPE means that future returns are likely to be disappointing. The average annualized return over the next three years when the CAPE is above 22-times earnings trends is less than 5%. It also increases drawdown risk dramatically. The average drawdown over the next three years when the CAPE is above 22-times is around -21%. We passed the 22-times mark four years ago, so this episode is already an outlier.
Asymmetry worries aside, we continue to see U.S. equities as extremely expensive, making the market vulnerable to any news that upsets the industry consensus on moderate growth, low inflation and low interest rates.
The two biggest risks we foresee here are a recession or inflation scare that sends interest rate expectations significantly higher. However, both seem unlikely in the near term. Another worry of ours is the potential for a sharp spike in volatility. The low level of the CBOE Volatility Index® (VIX Index) underlines the degree of investor complacency. The issues that could cause a volatility spike are hard to predict, but an obvious current candidate is the tension around North Korea.
Overall, we have a broadly neutral view on global equities. We’re underweight on U.S. equities because of expensive valuation. Positive cycle views and relatively better valuation give us small overweight positions to Europe, Japan and emerging markets. Going forward, we’ll look to the overbought/oversold indicators to guide us in buying dips and selling rallies.
Treasuries: Cycle, value and sentiment point to rising yields
Switching over to Treasuries, we find government bonds expensive across the globe. U.S. 10-year Treasuries around 2.2% are closest to our fair value estimate of 2.7%. German 10-year Bunds at 0.4% are some way from fair value of 1.5%, as are UK 10-year Gilts at a yield of 1.4% and fair value of 2.4%.
Overall, we see the cycle moving in favor of higher yields. The European Central Bank (ECB)’s tapering of bond purchases next year will likely put upward pressure on the term premium, as will the Fed’s plans to slowly reduce its holdings of Treasuries.
What’s been surprising to us is the low inflation in the U.S.—core inflation was just 1.7% in July. We believe this should start to pick up in the coming months, as the unemployment rate has been below 4.5% since March and many indicators show that the economy is near full capacity. We think that the 10% decline in the U.S. dollar index this year should also start to show up in import price inflation.
Interest rate markets are pricing in less than one Fed rate hike until the end of 2018, but we think that two to three rate rises are likely given the inflation backdrop. We feel markets are underestimating the potential for U.S. inflation pressures and Fed rate hikes in 2018.
Overall, we like local currency emerging markets debt from both a value and cycle perspective. We’re slightly underweight in high yield credit because of expensive valuation against a broadly neutral cycle outlook. We’re also slightly underweight in global government bonds. Fed tightening and likely ECB tapering are negatives for our cycle view, while regional bond market valuation ranges from slightly expensive in the U.S. to very expensive in Germany.
From a global perspective, sentiment is turning negative for government bond markets with the recent rally triggering overbought signals. Expensive valuation plus a more negative cycle outlook points us to a modest upward trend in global yields over the next year.
Currencies: Euro still has upside
The big story of 2017 so far has been the weakness in the U.S. dollar (USD) and the strength in the euro. We expect the euro strength to continue. Our process marks the euro as about 10% undervalued right now—and we see the business cycle turning more favorable as the economy picks up, the ECB winds down quantitate easing (QE) and political risks subside. The next Italian general election due in early 2018 is looking less ominous. Anti-euro political rhetoric is being toned down following the failure of populist political messages in the recent Dutch, French and German elections.
We think that sentiment is a tailwind for the euro, as it has solid upward momentum, but is tempered by some overbought signs. The ECB is the main factor standing in the way of further euro strength. It could start warning about the disinflationary impact of euro appreciation and potentially delay the tapering of QE should the euro rise too quickly.
By contrast, we view the U.S. dollar as expensive, even after falling 10% in trade-weighted terms this year. The dollar is in a downward trend, and this could continue for a few more months if weak inflation keeps Fed policy unchanged through December. In our view, the cycle is likely to turn more dollar positive in 2018 if, as we expect, the Fed signals more aggressive tightening intentions than investors currently expect.
Our main message for the close of 2017 isn’t much different from our opening one: we maintain our “buy the dips and sell the rallies” mantra. We believe that steady moderate growth, low inflation and relatively loose monetary policies in developed economies have combined to create a “sweet spot” for investors on a global scale—but we continue to urge caution in an expensive U.S. equity market, and see better opportunities in Europe and Japan.