In terms of the breadth of global growth, the first half of 2017 is shaping up to be the best start to a year since 2011. A surge in economic momentum in Europe and Japan, and solid corporate earnings globally, amply offset some wobbles in the hard data and a below-expectations print for US first quarter growth.
Equities, unsurprisingly, posted handsome gains as a result; but even so, investor sentiment appeared more cautious than price action might imply. The decline in bond yields, however, might paint a different picture. Although bond yields and equity prices have diverged previously in this expansion, the deviation is now raising questions about the reflation trade and, in turn, Fed policy. Whether the level of bond yields is a warning of slowing economic momentum, or merely the result of a savage short squeeze and the third year running of negative net G4 sovereign supply, remains a critical consideration in positioning for the remainder of 2017.
We expect the global economy to deliver trend-like growth in the second half of the year. The dip in US inflation looks to be bottoming, and both financial conditions and inventory data suggest any slowing of manufacturing momentum will be modest and transient. The expansions in Europe and Japan are robust, with all key segments of the economies participating in the upswing, and emerging market (EM) economies too are showing improvement despite the slight slowing in China’s pace of growth. By contrast, the optimism over US fiscal stimulus has largely dissipated, notwithstanding some lingering hopes of tax cuts this autumn.
With the US at full employment and the economy moving into late cycle, overzealous policy tightening is the biggest threat to our constructive view. But the mood music from the Fed, indicating a gradual upward path of rates and the prospect of balance sheet reduction later in the year, remains reassuringly consistent despite some recent outliers in economic data. In our view, a roughly quarterly pace of hikes remains in sync with prevailing economic momentum and should not hamper our positive view of asset markets.
In our asset allocation, we remain overweight (OW) equities and underweight (UW) duration globally. As the US economy moves toward later cycle, our one change at an asset class level is to trim credit from OW to neutral, reflecting that while credit will likely continue to outperform government bonds, it is unlikely to outpace stocks. Elsewhere, we maintain a neutral view on both real estate and commodities.
Within equities, the low level of inter-regional equity index correlation, together with the broad-based global upswing in growth, points to a diversified equity exposure across regions. Nevertheless, our quant signals and our fundamental analysis lead us to a marginal preference, in approximate order, for Japanese, European and EM equities over US and UK stocks; thus we maintain an OW to Japan, Europe and emerging markets and an UW to UK stocks. We acknowledge the full valuations of U.S. stocks, but prefer to keep a small OW exposure, as all-in yields remain compelling, and should we see tax cuts back on the agenda it would likely give a boost to US earnings.
For bonds, we believe that current yields will prove to be the low end of the 2017 range as recent softness in inflation clears and global economic momentum persists. With 2018 set to be the first year of positive net G4 bond supply since 2014, we see scope for global yields to slowly rise in the second half of 2017. We expect German Bunds to lead other markets to higher yields as better growth, fading political risks and the prospect of tapering of the European Central Bank’s bond purchases weigh on core eurozone bond prices. The path of bond yields is also likely to prevent any renewed US dollar strength, and while we see some modest upside against the Japanese yen, we expect other major dollar crosses to settle into a range.
Our portfolio reflects a core view of persistent, trend-like global growth that will translate into modestly higher levels for both yields and earnings. The muted sentiment among investors and corporates alike may well delay the type of exuberance that can precede the end of an economic cycle. But later-cycle economies are, by definition, already quite mature, so our moderately pro-risk tone is accompanied by careful diversification and ongoing scrutiny of any dips in data.
John Bilton is head of Global Multi-Asset Strategy, JP Morgan Asset Management