- Global economic activity may be peaking, but the synchronized global expansion continues to provide a supportive backdrop for international stocks.
- Recession risks in the US remain low.
- Rising global inflation risks will likely translate into greater market volatility.
- Emerging-market equities may not benefit as much from the typical inflationary pressures and rising commodity prices seen historically when the US has drifted into the late cycle.
The synchronized global expansion has been a primary driver behind the exceptional performance of global stocks over the past 2 years. The acceleration in global industrial activity and trade volumes underpinned a widespread increase in corporate profit growth and business sentiment. In 2017, international equities outperformed US markets for the first time in 5 years.
The typical business-cycle road map for asset allocation—based on historical patterns—has tended to favor international stocks over US stocks as an economic expansion becomes more mature. Traditionally, the US economic cycle has generally matured more quickly than the rest of the world, implying other economies have tended to maintain more mid-cycle properties even as the US drifted into the late-cycle phase. The US late cycle has traditionally been characterized by growing inflationary pressures and rising commodity prices, which have tended to boost emerging-market (EM) equities due to their exposure to commodity exports and strong global growth. As the current US expansion pushes toward the end of its ninth year, a key question is whether those historical patterns are still a worthwhile guide.
Global business cycle in solid expansion, though activity likely peaking
We begin, as always, with a look at the current state of the business cycle. Currently, almost all of the world's major economies are in an expansionary phase of the cycle, as 2017 rendered the most synchronized global reacceleration in several years (see chart 1). This expansion has occurred across both developed and emerging economies—leading economic indicators for nearly 80% of the world's largest 40 countries are rising—and recession risks around the world are extremely low.
Business cycle framework
Many countries in core and peripheral Europe are enjoying above-trend growth, with the eurozone as a whole in a solid mid-cycle expansion.
- Initially bolstered by reaccelerating manufacturing sectors, the eurozone expansion has broadened. Labor markets have tightened somewhat, and various surveys of both consumer and business sentiment have risen to cycle highs.
- Company profitability reaccelerated during the past year, with earnings growth bouncing from double-digit year-over-year percentage declines in late 2016, to up more than 25% at year-end 2017.
The United States is experiencing a mature expansion, with mid-cycle dynamics and some hints of late-cycle trends.
- Company profitability has reaccelerated meaningfully in the past year, and the tax cut legislation is providing an additional boost to earnings, cash positions, and business confidence.
- However, tighter labor markets continue to support growing wage pressures, suggesting profit margins have peaked.
- The Federal Reserve will likely have confidence to continue tightening monetary policy in these conditions, and we expect over time this will translate into less benign financial conditions and other later-cycle trends.
In China, policymakers have increasingly taken a tighter stance.
- With stated objectives of reining in excess leverage and improving the quality of growth, policymakers have dialed back fiscal, monetary, and regulatory stimulus that helped drive the Chinese and global reacceleration in 2017.
- Measures of industrial activity and credit growth have decelerated materially in recent months, which makes us concerned it may begin to negatively dampen global manufacturing and trade activity over time.
Inflation risk rising
With China showing early signs of deceleration and most major economies in more mature phases of the business cycle (mid-cycle phase or beginning of late-cycle phase), our view is that global activity may be peaking. We believe that the likelihood of an upside surprise in global inflation in 2018 is higher than an upside growth surprise.
- In the developed world, disinflationary pressures appear to have receded, and inflation is even showing signs of firming. Core inflation in the eurozone has been on a steady rise over the past year, and Japan is beginning to see early signs that tight labor markets are pushing up core inflation.
- Commodity prices are on the rebound as well, with oil prices rising more than 50% since June 2017. Even if they do not continue to rise and stay at current levels, they would likely push up headline inflation in the United States to around 2.5% by mid-year 2018.
- While we don't expect a dramatic acceleration in inflation in 2018, global inflation appears firm and there are upside risks given low investor expectations.
Does higher technology weight make emerging markets less attractive in the late-cycle phase?
For most of its nearly 30-year history, the emerging-market (EM) equity universe has sported a hefty direct exposure to commodity-producing companies in the energy and materials sectors. While the exact weight in the MSCI EM index has oscillated, energy and materials stocks have generally accounted for between 20% to 30% of the overall index. The widespread impact of commodity prices on the broader economies, financial flows, and fiscal balances of emerging markets has further cemented a tight correlation between commodities and the performance of EM equities.
During the past 5 years, however, the importance of the technology sector—particularly large Chinese tech companies—has grown dramatically. Technology stocks now account for 28% of the EM equities universe, roughly twice as much as commodity-linked sectors (See chart 2).
Due to the changed sector composition of the EM universe, it's possible EM equities as a whole may not react in a manner perfectly consistent with prior cycles. Less direct commodity exposure implies that EM stocks could potentially benefit less from a traditional US late-cycle phase filled with inflationary pressures and rising commodity prices. In addition, the valuation of the EM technology sector is near an all-time high. This makes EM more susceptible to any deterioration in current growth stock momentum or a softening in cyclical tech industries that often occurs during the latter stages of expansion.
Will a weaker US dollar boost foreign equities?
A year ago, we believed the US dollar was overvalued and foreign currencies were poised to rise in value given the under-appreciated trends of firming global growth and inflation. After the dollar has dropped roughly 10% against major currencies over the course of the past 12 months, the dollar is more fairly valued, although it remains relatively expensive compared to its average over the past 2 decades (see chart 3).
Exchange rates are influenced in part by the relative rate of return on investments, such as bonds, in different countries. These rates of return are influenced by anticipated movements in bond yields and monetary policies. A possible supportive factor for foreign currencies is that bond yields and monetary policies in some major countries have been slow to respond to firming growth and inflation trends.
For example, short-term interest rates in the eurozone are still expected to remain around today’s levels for the next 12 months, and below 0 for the next 3 years. The market's outlook for European monetary policy is in contrast to the US, where futures markets suggest 2 to 3 additional hikes from the Federal Reserve (Fed) in 2018. The 2-year US Treasury yield, a good proxy for the market’s expected future path of policy rates, has continued to widen versus German 2-year bond yields and is near all-time highs (see chart 4).
We think the market may be expecting a slower shift away from monetary easing in Europe and Japan than will actually occur. Growth in both Europe and Japan is above trend levels, inflationary pressures are rising, and these conditions appear firm enough to warrant a move toward policy normalization that would generally support those currencies. We're not sure that currency movements will provide a significant boost to the returns of international equities (for US investors), but we're not expecting a strong dollar to be a headwind.
Secular thoughts: Valuations, growth, and diversification still supportive
Beyond the intermediate-term cyclical view, our long-term perspective remains that a global equity portfolio should have a healthy exposure to non-US stocks. Price-to-earnings ratios of international equities are well below those of the United States, and valuations are an important driver of long-term returns (see chart 5). We expect GDP growth in emerging-market countries to outpace the United States, providing a favorable secular backdrop for EM equity opportunities. Meanwhile, while international markets have grown more correlated with US stocks in recent decades, the diversification benefits of owning global equities would rise if political threats to globalization manifest themselves by breaking down some of these linkages.
Asset allocation outlook
Financial markets have entered 2018 with impressive momentum in the global corporate and economic backdrop. We believe growth and inflation are firm enough to keep global policymakers moving toward a reduction in monetary accommodation. While this process is likely to happen gradually, the neutralization of extra liquidity growth that has provided fuel for asset prices in recent years is likely to provide an impetus for market volatility to rise from currently low levels.
From an asset allocation standpoint, this expectation for potentially higher volatility implies that smaller cyclical portfolio tilts are warranted at this stage of the business cycle. We remain constructive on global equities and still favor international equities (both developed and emerging) relative to US stocks on a cyclical basis.
However, we are less confident that emerging markets will be a beneficiary of a full late-cycle environment as the typical business-cycle playbook suggests, and we believe exposure to inflation-resistant assets is important.