Executive summary

The monetary policy tide is heading out, putting upward pressure on government bond yields. Momentum can drive equity markets higher, but we believe extremely stretched U.S. equity valuation makes the market vulnerable to any unwelcome news.

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Turning tides

The great tide of global monetary policy support that started nearly a decade ago is now receding. The Federal Reserve (Fed) is starting the slow process of balance sheet reduction and is on a gradual path to raise the federal funds rate, the European Central Bank is poised to start tapering its asset purchases in 2018 and the Bank of England has hinted at a rate rise in November. Only the Bank of Japan stands resolute in its commitment to ultra-expansionary monetary policy.

The implication is that the period of declining long-term interest rates is over. Yields, of course, can rally on softer economic news, but the lows have been seen for this cycle and the slow path to normalization is underway.

Our cycle, value and sentiment (CVS) investment decision-making process has us broadly neutral global equities. We’re underweight U.S. equities because of expensive valuation. Positive cycle views and relatively better valuation give us small overweight positions to Europe, Japan and emerging markets within global equities.

Paul Eitelman sees a mediocre U.S. economy and corporate earnings supported by strength in the rest of the world. Contrary to the industry consensus, he thinks the Fed will remain on hold in December, but he also expects a more aggressive Fed in 2018.

In Europe, Wouter Sturkenboom sees the tailwinds of robust growth and favorable politics outweighing the headwinds from the rising euro. Equity market valuation is reasonable, in contrast to the U.S. This underpins our relative preference for Europe.

Graham Harman and Alex Cousley are becoming more constructive on the Asia-Pacific region. China’s National Congress in October should provide further progress on the tricky task of combining structural reform and deleveraging with ongoing economic growth. The outlook for Japan is firming with gross domestic product (GDP) surprising to the upside, and Australia’s economy is improving. The main note of caution comes from the tensions around North Korea.

Van Luu thinks euro bullishness is a crowded trade and could stall the rally near-term. He sees more euro upside in 2018 but is skeptical that the British pound’s strength can be maintained and thinks the Japanese yen will stay under downward pressure.

The U.S. business cycle index model estimated by Kara Ng and Abe Robison points to rising recession probabilities. We’d expect such after a long economic expansion, though in our view the model’s predicted probabilities are not yet at alarming levels. It is, however, a note of caution, and we will monitor this model closely over coming quarters.

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