The Multi-Asset Teams Views on Asset Allocation
The global economy continues to grow above trend and remains in a strong cyclical position, further supported by accommodative monetary conditions and a lack of inflationary pressures. In recent weeks, economic data releases have shown some moderation in growth momentum, which was inevitable given the strong economic performance of the past 12-18 months. Our leading economic indicators suggest some near-term slowdown in developed markets, while emerging markets remain in expansion. Global market sentiment continues to improve, and it was only marginally shaken by headlines on tariffs and trade protectionism. We believe this environment remains fairly constructive for risky assets globally, with positive (yet diminishing) expected returns in the medium term.

Following are our views on major asset classes and our current positioning in them.

U.S. Equities

  • We maintain a moderate overweight exposure to U.S. equities, supported by this late expansion phase of the business cycle. Among style factors, we expect momentum to continue to outperform, currently coinciding with growth and technology stocks.
  • The U.S. economy continues to expand at a rapid clip, now benefiting from strong global growth, tailwinds from fiscal expansion, and still negative real rates.
  • There are no clear catalysts for an enduring correction in US equities at this stage. However, recent headlines around increasing tariffs on several imports (i.e. washing machines, steel, and aluminum) may provide some near term volatility, which we expect to dissipate after a few weeks.

European Equities

  • We reduced our overweight to European equities, waiting for more evidence of local equity markets keeping up with US equities.
  • European growth is at its strongest pace in a decade. The unemployment rate is the lowest in 8 years, while business and consumer confidence make new cycle highs. Consensus expects 2018 growth around 2.2%, which we believe to be too conservative.
  • While European equities have done well, the main beneficiary of strong European growth has been the Euro, rather than local equities, which continue to lag US equities both in terms of performance and positive earnings revisions.

Emerging Markets Equities

  • We maintain an overweight exposure to EM equities, the largest in the portfolio in relative terms, as we expect the asset class to offer some of the most attractive returns over the next few years.
  • Emerging markets exited their “recession” in early 2016, and are currently in the early stage of a new expansionary cycle, supported by strong external demand, rising commodity prices and low inflation. China continues to successfully manage its rebalancing from investment to consumption growth.
  • Under this economic backdrop, coupled with rising global risk appetite, emerging equities are well positioned to outperform most asset classes.

Emerging Markets Fixed Income

  • We are overweight emerging markets local debt expecting a stable income source coupled with modest price appreciation from local currencies, which we believe to be attractively valued, and supported by tailwinds from commodity prices.
  • After two consecutive years of double-digit returns1, emerging markets local debt remains an attractive medium-term holding, especially for portfolios with a diversified income objective.
  • While spreads to U.S. Treasuries have compressed by about 150bps since 2015, the yield on the asset class remains above 6%, with stable average inflation around 4% and a real yield of 2%, well above the negative real yields available in developed fixed income markets. Inflation continues to surprise to the downside for the ninth consecutive year, supporting bond prices.

Foreign Currencies and the U.S. Dollar

  • We favor the Euro and the Japanese yen. We expect EM currencies to perform well, supported by equity inflows and rising commodity prices.
  • We expect the dollar to weaken further in 2018, given positive growth sentiment outside the United States. Similar to what happened in 2017, dollar weakness is taking place despite Fed rate hikes, as currencies have not been driven by interest-rate differentials. Instead, trade flows and growth-sensitive capital flows, such as equity and foreign direct investment, have been driving currency trends. This is reminiscent of the period 2004-2006, when the dollar weakened despite the Fed hiking rates ahead of other central banks.

U.S. Credit

  • We hold underweight positions in our portfolios for U.S. high grade and high yield. Although credit markets should remain fairly stable through 2018, upside is limited, and we expect returns mostly from income rather than continued price appreciation.
  • While on a gradual tightening path, monetary conditions remain broadly accommodative as indicated by ongoing easing in lending standards and accelerating growth. This macro backdrop suggests the United States is still in the mid-phase of the credit cycle, where the asset class serves primarily as an income objective.

Government Bonds

  • We hold a moderate duration underweight in both U.S. and developed markets fixed income.
  • Major central banks are going far and beyond to deliver gradual exit strategies after a decade of unprecedented monetary easing. Their main goal remains clear: policy normalization while minimizing market impact. We believe they will successfully continue doing so in 2018.
  • While we don’t believe interest rates will rise meaningfully and crash bond markets, government bonds do not offer attractive returns, as strong global growth and improving risk appetite provide headwinds to the asset class.

Alternatives

  • We continue to see a constructive environment for metals and oil prices, now hovering between $60-$70, driven by global demand running in excess of production, as indicated by falling inventories.
  • Cyclical commodities such as metals and energy have bottomed out in early 2016, supported by improving manufacturing, capex and global trade cycles.
  • We maintain a significant position in catastrophe bonds.
  • This asset class continues to offer attractive diversification potential versus other bond-like sectors. In addition, catastrophe bonds currently offer high expected risk adjusted returns, following losses around 2H 2017 hurricane and wildfire events.

Main Risks to Our Views

  • Central banks: We do not believe inflation is a meaningful threat, but it is nonetheless likely to rise modestly in the medium term given the rising capex cycle, tighter labor markets and rising commodity prices. An increased urgency by central banks to tighten financial conditions could meaningfully derail risky assets, especially high yield credit, followed by equities.
  • Disruptive trade negotiations and increasing tariffs: Rising trade tensions between the United States and China have already led to increased tariffs on several U.S. goods imports (washing machines, solar panels, steel, etc.). Furthermore, NAFTA negotiations remain fluid and recent comments by Treasury Secretary Mnuchin on the U.S. dollar highlight the risk of dysfunctional trade relations.
 
  1. ^See JPMorgan GBI-EM Global Diversified Index.