The two key global market trends of early 2018—U.S. growth leadership and the U.S. dollar (USD) bounce—have probably run their course. Be alert for an escalation in the trade–war issue, and keep an eye on the yield curve for a U.S. recession warning, although this seems unlikely before late 2019.
Key market themes
We maintain an underweight preference for U.S. equities in global portfolios, primarily on the back of their expensive valuations. The cyclically adjusted price–to–earnings ratio for the S&P 500® Index—commonly called the Shiller P/E ratio—stands at 32x in June 2018, which is its highest level outside of 1929 and the late 1990s. Our “valuation” conditional framework as of mid–year suggests the expected total return on U.S. equities over the next decade is likely to be very subdued—at only about 2% per year. Our underweight preference for U.S. government bonds and interest rate risk from prior years has shifted to neutral, as a 3% U.S. 10–year Treasury yield better reflects our macro outlook and the risks surrounding U.S. Federal Reserve (the Fed) policy and inflation.
We believe Asia–Pacific valuations are fair priced to slightly attractive across the region. We continue to like Japanese valuations and believe that part of the rise in Japanese profit margins is structural (rather than cyclical). Australia is close to fair value in our view. Developing Asia looks attractive, with the caveat that China H–shares are expensive due to the Chinese tech names. We expect to see solid performance out of the economic data and equity markets in the region, underpinned by strong Chinese activity, robust global growth and supportive policy. However, an escalation in trade tensions or further strengthening in the U.S. dollar remain key risks.
We are neutral on eurozone equity valuations, while we see core government bonds as long–term expensive. We decided to slightly alter our range for eurozone core bond yields from 0%–0.8% to 0.2%–1.0% to line up with the low point in yields during the Italian political flare–up. We went underweight Italian bonds in April and moved to overweight subsequently in two steps when valuations jumped from expensive to cheap. We continue to favor eurozone financial markets over U.S. markets in particular. The push from strong fundamentals, relatively attractive valuation and supportive monetary policy will likely combine to outweigh the pull from increased political risk.
While UK equity valuations have become slightly cheap on our scorecard at mid–year 2018, we continue to advocate caution given the uncertainties surrounding Brexit as well as the economic slowdown. Government bond valuations are long–term expensive, but at 1.3% the current 10–year Gilt yield is well within our expected range of 1.0%–1.8% for 2018.
Canadian valuation measures such as price–to–earnings and price–to–book continue to improve on the back of encouraging energy earnings fundamentals. We remain largely neutral in an absolute sense, but are modestly positive toward Canadian equities relative to the U.S.
- The main economic data trend has been the growing gap between the economic performance of the U.S. and the rest of the world. The manufacturing purchasing managers’ index (PMI) for the U.S. has trended higher this year, while Europe and Japan have reversed some of last year’s gains.
- This theme of U.S. growth leadership is one reason U.S. equity–market returns have outpaced those in Europe and Japan in the first half of 2018. We expect a rotation away from the U.S. in coming months.
- Data surprise is cyclical and we believe Europe should rebound to positive surprise as industry consensus forecasts are downgraded and the region maintains its above–trend growth path.
- Our one–year to 18–month outlook favors regions with the potential for low inflationary above-trend growth, continued accommodative policy settings and corporate margin expansion. This puts Europe, Japan and emerging markets in our view ahead of the U.S. in the cycle pecking order.
Asset class views
Equities: Broadly neutral
Our cycle, value and sentiment (CVS) investment decision–making process holds us at a broadly neutral weighting on global equities. We have a small preference for Europe, Japan and emerging markets over the U.S., and expect that the U.S. 10–year Treasury yield has limited upside. We see the U.S. dollar bounce as having run its course.
Fixed income: Fair value at 2.6% in the U.S., very expensive elsewhere
3% has proven a strong resistance level for the 10–year U.S. Treasury yield. Our fair value estimate is 2.6% as of mid–year 2018. This is based on our expected path for the Fed funds rate over the next few years plus the term premium. It includes our expectation that the U.S. will possibly experience a recession by 2020, which means the Fed likely will be lowering rates by then.
German bunds, UK gilts and Japanese government bonds (JGB) are very expensive, based on our methodology. The cycle forces on JGBs and gilts are broadly neutral and unlikely to push yields higher. The Bank of Japan remains committed to “yield curve control” and is targeting the 10–year JGB yield to remain below 0.1%.
The cycle is moving against bunds as the European Central Bank (ECB) approaches tapering and inflation pressures build. This makes bunds our least preferred government bond exposure.
Currencies: Neutral on U.S. dollar
We retain an overall neutral view on the U.S. dollar (USD). The USD dollar trade–weighted index has rebounded 5% since mid–April, reversing some of the downward trend since the beginning of 2017. Our cycle, value and sentiment (CVS) investment decision–making process suggests that the upside for the USD is limited from here. We estimate that the USD is around 10% overvalued in purchasing power parity terms against a basket of developed market currencies.
Cheap valuation, a healthy current account surplus and the expected gradual exit from the ECB’s loose monetary policy keep us constructive on the euro. The Japanese yen is still our favorite G10 currency based on its attractive value and safe–haven characteristics.
The views in this Global Market Outlook report are subject to change at any time based upon market or other conditions and are current as of June 22, 2018. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.
Keep in mind that, like all investing, multi-asset investing does not assure a profit or protect against loss.
No model or group of models can offer a precise estimate of future returns available from capital markets. We remain cautious that rational analytical techniques cannot predict extremes in financial behavior, such as periods of financial euphoria or investor panic. Our models rest on the assumptions of normal and rational financial behavior. Forecasting models are inherently uncertain, subject to change at any time based on a variety of factors and can be inaccurate. Russell believes that the utility of this information is highest in evaluating the relative relationships of various components of a globally diversified portfolio. As such, the models may offer insights into the prudence of over or under weighting those components from time to time or under periods of extreme dislocation. The models are explicitly not intended as market timing signals.
Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.
Investment in global, international or emerging markets may be significantly affected by political or economic conditions and regulatory requirements in a particular country. Investments in non-U.S. markets can involve risks of currency fluctuation, political and economic instability, different accounting standards and foreign taxation. Such securities may be less liquid and more volatile. Investments in emerging or developing markets involve exposure to economic structures that are generally less diverse and mature, and political systems with less stability than in more developed countries.
Currency investing involves risks including fluctuations in currency values, whether the home currency or the foreign currency. They can either enhance or reduce the returns associated with foreign investments.
Investments in non-U.S. markets can involve risks of currency fluctuation, political and economic instability, different accounting standards and foreign taxation.
Bond investors should carefully consider risks such as interest rate, credit, default and duration risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage-backed securities, especially mortgage-backed securities with exposure to sub-prime mortgages. Generally, when interest rates rise, prices of fixed income securities fall. Interest rates in the United States are at, or near, historic lows, which may increase a Fund’s exposure to risks associated with rising rates. Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries.
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