- World-wide, we are experiencing the most synchronized global expansion in years.
- Growth risks include tighter monetary policy and a China growth slowdown.
- An overweight to risk assets like stocks and high-yield bonds remains warranted.
- Equity valuations look relatively attractive in most foreign developed markets.
- Volatility may increase. Stay diversified.
Each quarter, Fidelity's Asset Allocation Research Team (AART) compiles a comprehensive quarterly market update. Here is a summary of their outlook, plus four key investor takeaways for the second quarter of 2017. For a deep dive into each, read the Quarterly Market Update: First Quarter 2018 (PDF) or the interactive PDF.
The year 2017 was defined by a near-perfect backdrop of steady global growth, low inflation, and accommodative monetary policies, which helped fuel a broad-based rally in asset prices.
Non-US stocks outperformed the US stock market for the first calendar year in the past 5, bolstered by a weaker dollar and a strengthened economic backdrop. Credit spreads tightened amid the “risk-on” tone, boosting emerging-market and high-yield bonds. Steady longer-term interest rates kept high-quality bonds in the black, and all major asset categories posted positive returns.
Global assets experienced remarkably low levels of volatility. Since equity markets hit a bottom in early 2016, riskier assets have registered gains far above their long-term historical averages, even as their price fluctuations were far below average. In the United States, stock-price moves were particularly tranquil during 2017.
The year 2017 was a rare year, featuring an accelerating global economy accompanied by a large outperformance for growth stocks relative to their value counterparts, somewhat reminiscent of the large-cap technology stock leadership of the late 1990s. Emerging-market (EM) gains in 2017 were also spearheaded by tech stocks, which became the largest sector in the EM equity index and roughly twice the weight of the sum of the energy and materials sectors.
Economy/macro: Synchronized global economic expansion continued, but monetary policy shift poses a risk
The global economy in 2017 continued to experience the most synchronized expansion in years. Broadly speaking, most developed economies are in more mature (mid-to-late) stages of the business cycle, with the eurozone not as far along as the United States. Global recession risk remains low, but moving forward, less accommodative policy in several developed and emerging countries may constrain the upside to growth.
The global expansion continues to be underpinned by solid global export and manufacturing sectors. China’s rising import demand over the past year has helped push the percentage of major countries with increasing new export orders to nearly 90%. The outlook for global trade, industrial activity, multinational profits, and commodity prices will be determined largely by China’s cyclical trajectory. Chinese policymakers have begun to tighten financial conditions, resulting in the sharpest deceleration in credit growth in nearly a decade. While China’s economy remains broadly steady, less-supportive policies make the outlook more uncertain and a growth deceleration probable.
The US economy has remained on a very gradual progression through its business cycle, with mid-cycle dynamics remaining solid and just a few hints of late-cycle trends. As is customary during a late-cycle phase, corporate profit margins have declined from peak levels, but restrained wage growth and robust global conditions have allowed margins to stay high and corporate profit growth to remain firm. With the unemployment rate at a cyclical low of 4.1%, tightening labor markets continue to boost consumers, keep US recession risk low, and support wage gains.
Keep an eye on the yield curve. It’s been an important indicator, having inverted before the previous 7 US recessions. In December, the Federal Reserve hiked policy rates for the third time during 2017, pushing up short-term rates and causing the yield curve to flatten by about 100 basis points. The curve, however, remains positively sloped and steep relative to prior late cycles, and credit and financial conditions have yet to tighten measurably.
Global inflation remained tame in 2017, but appears to be firming. Eurozone core inflation has been on a steady rise, and Purchasing Managers' Indexes in almost all of the world’s largest economies have reported rising prices. In the US, inflation will likely remain firm even if oil prices don’t continue to rise. We don’t expect a dramatic acceleration in inflation in 2018, but there are upside risks given low investor expectations.
In addition, we believe growth and inflation are firm enough to keep global policymakers moving toward a reduction in monetary accommodation. Growth in major central bank balance sheets is set to drop by $1.4 trillion over the next 12 months as the Fed winds down its balance sheet and the ECB pares back on quantitative easing. The deceleration in liquidity growth may neutralize a key support for riskier asset prices and lower volatility.
New tax legislation may help boost business confidence and make more cash available to corporations, and some of the proceeds from tax cuts and foreign-earnings repatriation might go toward additional capital expenditures. After years of corporate under-investment, however, any cyclical uptick in CapEx may take a while to boost productivity growth, which typically follows CapEx growth on a lagged basis.
We estimate the tax legislation will provide a modest 0.3% boost to GDP over the next couple of years, with the cyclical impact limited by a muted multiplier effect. Easier fiscal policy and rising deficits may put upward pressure on inflation and bond yields.
Asset markets: Growth, tech, non-US stocks led broad market rally in Q4 and 2017
Growth and emerging-market stocks continued as strong performing categories in the fourth quarter, fueled by the information technology sector. For the year, all major equity categories and sectors ended with double-digit gains, except for energy and telecom stocks. Fixed income had modest returns in the fourth quarter, but all bond categories and sectors posted positive returns for the year.
Turning to fundamentals, after several years of profit recession, international corporate earnings accelerated for several quarters and surpassed US corporate profit growth in 2017. Earnings revisions also stabilized for the first time in years, although lofty forward-earnings-growth expectations may provide a tougher hurdle to clear in the year ahead, particularly in emerging markets.
In terms of valuations, on a one-year-trailing-earnings basis relative to their own histories, US price-to-earnings ratios are above average, developed markets overall are below average, and emerging markets are roughly average. All equity valuations have risen substantially over the past 2 years, although forward-looking estimates appear more reasonable. Using 5-year, peak-inflation-adjusted earnings, price-earning ratios for foreign-developed and emerging-stock markets remain lower than those in the United States, with many countries around the midpoint of their 20-year range. Despite dollar weakness in 2017, the value of most currencies also remains in the lower half of historical ranges versus the US dollar. Both factors provide a relatively favorable long-term valuation backdrop for non-US stocks.
Among fixed income categories, bond yields were mixed during the fourth quarter, with some categories rising slightly and 30-year Treasury rates falling. However, yields for all categories remain well below their historical averages. Credit spreads narrowed slightly during the quarter, making all credit sectors more expensive relative to their own histories.
Historically, the mid-cycle phase tends to favor riskier asset classes, while late cycles have the most mixed performance of any business-cycle phase. The late cycle has often featured more limited overall upside and less confidence in equity performance, though stocks have typically outperformed bonds. Inflation-resistant assets, such as commodities, energy stocks, short-duration bonds, and TIPS have historically performed relatively well here.
From an asset allocation standpoint, the current environment continues to warrant an overweight to risk assets. However, given the maturing US business cycle, the likelihood of less reliable relative asset performance patterns, and increased volatility as a result of the risks in the global monetary policy, smaller cyclical portfolio tilts may be warranted. The possibility of higher volatility underscores the importance of diversification.
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