- The global economy is experiencing a steady expansion, but global activity may have peaked as the cycle has matured.
- Uncertainties and risks—including aggressive US trade policy—may continue to drive volatility up and prices down.
- The US corporate backdrop remains strong, and pro-business policies have helped boost earnings expectations but countervailing forces have the potential to act against this backdrop of US economic strength.
Market summary: Crosscurrents fueled volatility at start of 2018
US tax cuts and fiscal stimulus helped firm inflation and growth expectations in the first few weeks of Q1, pushing up global equities and bond yields. Then market volatility surged, and most asset categories bounced around during the quarter before finishing in modestly negative territory. See our interactive presentation for in-depth analysis.
A number of crosscurrents catalyzed the spike in volatility amid an accumulation of US policy risks, including a sustained commitment to monetary tightening by the Federal Reserve (Fed), an aggressive trade posture by the US, and regulatory concerns around large technology companies.
Emerging-market stocks added to their stellar gains over the past year, but most global equity categories finished lower for the quarter. Gold held up well amid growing policy uncertainty. Solid US growth and monetary tightening pushed bond yields higher—10-Year Treasury yields rose to their highest level in 4 years—nudging most fixed income sectors into the red. However, in contrast to the "taper tantrum" in 2013, the recent rise in real yields and inflation expectations has been relatively gradual, moving alongside firmer economic fundamentals.
Economy/macro backdrop: Steady expansion, but global activity may have peaked as the cycle has matured
The global economy is experiencing a steady expansion, with low global recession risk. The global expansion continues to be underpinned by strong activity in the export and manufacturing sectors. However, there are some initial signs that global industrial activity may have peaked. The broad Chinese economy appears to be decelerating, as policy-makers tighten financial conditions to address excess leverage and overcapacity in the industrial sector. However, relative to China’s 2015 growth recession, housing activity and external conditions are more favorable and may be providing an offset.
The US economy is showing a mix of mid-cycle dynamics and late-cycle trends. As is customary during a late-cycle phase, tighter employment markets have pushed up wages, and the Federal Reserve's tightening of monetary policy has flattened the yield curve over the past year. However, credit conditions are not yet restrictive.
Moreover, the US corporate backdrop remains strong, and pro-business policies have helped boost earnings expectations. Lower tax burdens and access to offshore cash may provide companies with additional spending capacity, which they may use on a wide variety of activities, including investor-friendly actions (buybacks, dividends, M&A) as well as direct boosts to the real economy (raising wages, capital expenditures).
The multi-decade trend favoring business profits over wages has topped out, with tighter employment markets leading to a pick-up in wages and peaking profit margins. The pace of wage growth has been restrained amid excess slack in the labor markets, but the labor force participation rate has recently stabilized and labor markets are currently nearing full employment, supporting core inflation.
Headline inflation in the US has steadily risen since the middle of last year and will likely remain firm over the near term. Outside the US, inflation rates have remained tame, but evidence of price pressures continues to materialize. Japanese inflation has been on a steady rise from extremely low levels amid the tightest labor market since the early 1990s, potentially setting the stage for long-awaited wage inflation.
In the US, the combination of tax cuts and higher fiscal spending are likely to provide a modest boost to economic growth over the next couple of years, but the growth multiplier from fiscal stimulus is lower than it would have been earlier in the cycle. As a result, easier fiscal policy and rising deficits may also put upward pressure on inflation and bond yields.
A maturing business cycle suggests caution rather than portending disaster, and does not automatically imply a risk-off market environment. Late-cycle expansions often coincide with a peak level of activity, which historically has implied less upside for risk assets and a generally less favorable risk-return profile than earlier in the cycle.
One major risk to the global economy is the aggressive US trade posture. China and the US are the most central economies in the highly integrated global trade network. Plans by the US to confront China's trade and investment policies could ratchet up bilateral commercial tensions. The entities most at risk might be the countries, industries, and companies that are most dependent on global trade and supply chains.
We believe global growth and inflation are firm enough to keep policy-makers moving toward tighter monetary policy. The growth in major central bank balance sheets is set to drop by almost $2 trillion over the next 12 months, implying less liquidity for financial markets. We expect elevated market volatility due to peaking global economic momentum and risks to the monetary, political, and economic outlooks. Smaller asset allocation tilts are merited at this point in the cycle.
Asset markets: Volatility rises amid a weak quarter
Accumulating uncertainties and risks drove volatility up and prices down, with nearly all major stock and bond categories in negative territory. In the US, small cap stocks and growth-oriented categories fared better than large caps and value categories. Across most international equity categories, a weak dollar provided a small boost for dollar-based investors. Rising interest rates weighed on long-duration fixed income categories.
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 performed relatively well.
The historical playbook has also tended to favor international equities over US stocks as an economic expansion matures. Because technology now represents a much larger percentage of emerging-market economies than commodities, broad emerging-market equity markets may not benefit as much as they have in the past if the US drifts into late cycle and global inflationary pressures rise. However, international equities may still benefit from global expansion, a favorable secular outlook, and cheaper valuations.
Global earnings continue to provide a solid fundamental backdrop for equity markets, though developed and emerging markets are showing signs of moderating growth. Earnings revisions outside the US also stabilized for the first time in years, although lofty forward earnings growth expectations may provide a tougher hurdle to clear, particularly in emerging markets. Equity valuations are above their long-term average in the US, below in developed markets, and roughly average in emerging markets. Lower non-US valuations provide a relatively favorable long-term valuation backdrop for non-US stocks.
In fixed income, yields and spreads generally remain at the lower end of the historical range, despite interest rates inflecting higher during the quarter. Credit spreads widened slightly amid higher asset volatility during the quarter, but remain relatively expensive compared to their long-term histories.
Over the longer term, we believe the global economy has reached a secular trend of peak globalization. Changes to global rules may pose risks for incumbent companies, industries, and countries that have benefited the most from the rise of a rule-based global order. These risks include potentially higher inflation, lower productivity and profit margins, and higher political risk. Several factors, including policy changes and peak-globalization trends, could potentially cause inflation to accelerate faster than many investors’ subdued expectations based on recent decades of disinflation.
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