When we look at what is worrying global investors, three factors account for the pervasive market skittishness we’ve seen in recent weeks: extrapolation of the soft patch in the US, fear over the impact of higher US rates and lingering skepticism over the global recovery. We also believe that many find the length of the current business cycle disorienting.
Notwithstanding soft first-quarter US data, most macro data points show the US economy in mid-cycle. It would be extraordinary for the US to move from a prolonged early-cycle phase directly to late-cycle before the Federal Reserve (Fed) raises rates, but this fear of “policy error” haunts investors. The impacts of the recent European crisis, and the long-term experience of Japan’s underperformance, are cut deep in investors’ memories.
There remains a divergence in growth and policy around the world, and while we expect this to persist through 2015, we also have faith that the world economy is improving. Rising wages and a slower pace of US dollar appreciation should limit the fallout from the Fed’s expected tightening in the third quarter. Meanwhile, European and Japanese policy stimulus is coming in tandem with better data trends.
We expect both data and policy to reinforce the notion that the US economy is in mid-cycle. Paradoxically, the very fear that the economy will lurch to late-cycle or slide into recession will probably restrain the exuberance that is common at the peak of a cycle.
This presents a supportive backdrop for equities. US stocks lagged in early 2015, but cuts to earnings expectations leave a low hurdle for positive surprise. Meanwhile, higher beta markets—Europe and Japan—continue to deliver on earnings as currency weakness boosts output. Central bank stimulus is keeping in place a bid for duration, even though disinflationary trends appear to be bottoming out.
Stock-bond correlations remain negative, meaning an overweight (OW) in bonds still effectively balances an OW in stocks. But as inflation expectations grind higher and the US starts to raise rates, bond yields—especially at the short end—have scope to rise.
Our conviction views are thus OW US and European equities, balanced by a modest OW in long-end US Treasuries, and we have moved to a small OW in credit. We remain OW US dollar and Japanese stocks but have trimmed the positions. By contrast, we are underweight (UW) short-end US Treasuries, emerging market (EM) equity, commodities and cash; we remain UW in euro (EUR) and pound sterling (GBP) but with smaller positions.
The downside risks of overzealous policy tightening or a currency crisis in emerging markets remain; on the upside, a more synchronized global recovery would give a powerful boost to risky assets and send bond yields higher. On balance though, we believe that the themes of divergent global policy, a gradual recovery in Europe and a rebound in US economic strength will dominate the middle part of the year. The growth scare from the first quarter should abate, and while we anticipate some volatility around the first Fed hike, we see a US economy in mid-cycle and a supportive backdrop for risk taking.
A large body of research finds that asset allocation is a critical, if not the critical determinant of a portfolio’s total return. We believe that a nimble, flexible approach to asset allocation, deployed in an unconstrained global strategy, can be especially effective. Because it allows a portfolio manager to uncover opportunities across markets and sectors, an unconstrained approach can be a powerful tool to deliver consistent total returns.
John Bilton is global head of Multi-Asset Strategy at JP Morgan Asset Management
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