Investment strategy outlook

We still want to buy dips and sell rallies against the backdrop of an expensive U.S. equity market, a broadly neutral earnings outlook, and sentiment indicators that point to complacency. Europe and, to a lesser extent, Japan and emerging markets (EM) have better cycle support. Government bonds are expensive, but a lack of global inflation pressure should keep yields in a range.

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Late-cycle lean out

In our previous quarterly report, we cautioned that investors were becoming overoptimistic about near-term U.S. economic growth prospects. Disappointment seemed likely, creating the potential for market volatility. Sure enough, U.S. economic data subsequently began to disappoint. The Citigroup Economic Surprise Index, which tracks U.S. economic data releases against consensus forecasts from economists, plunged from +60 in mid-March to -80 in late June.

The shift from positive to negative economic surprise triggered a 45-basis-point decline in the U.S. 10-year Treasury yield and a 5% fall in the U.S. Dollar Index. It hasn’t, however, generated a meaningful pullback in equities.

This points to the role of declining interest rates in supporting U.S. equity market valuation. Investors have embraced a type of cognitive dissonance; sky-high U.S. equity valuations say the outlook is fantastic, but low Treasury yields warn that the growth outlook is lackluster. The U.S. equity market is being supported by a view that growth will remain reasonable and interest rates will stay low. This means the market is vulnerable to either of those assumptions being questioned: either a recession scare or a rising interest rate scare. We believe both scenarios seem unlikely in the near term.

U.S. economic surprise index

Source: Citigroup, last observation June 21, 2017.
Performance quoted represents past performance and should not be viewed as a guarantee of future results. Indexes are unmanaged and cannot be invested in directly.

The challenge of 2017 is that we are in a late-cycle, momentum-driven market where valuation is at an extreme. Momentum can drive markets beyond fundamentals for an extended period. No investment process is going to pick the peak in the cycle, but it should lean out as the risks increase.

Our cycle, value and sentiment investment analysis process tells us to be cautious about U.S. equities. Expensive valuation implies asymmetry in the return outlook, where the potential downside is larger than the upside. But the absence of significant U.S. recession risk means the cycle is broadly neutral for equities. This stops us from being too bearish. Overbought sentiment stops us from chasing the current momentum-driven rally. We’re still in a “buy the dips and sell the rallies” market environment. We want to lighten up in the current rally and look to buy the next dip.

Key indicators update

Our 2017 annual outlook report listed three indicators we would watch closely in 2017: U.S. wage measures, fiscal policy announcements and emerging markets exports.

  • U.S. wage growth has moved sideways this year, despite the unemployment rate declining to 4.3% in May. This is reducing the pressure on the U.S. Federal Reserve (the Fed), which is under pressure to lift interest rates further. We expect that the Fed funds rate will be held steady for the rest of 2017.
  • Fiscal policy is providing a modest boost to growth this year, but the recent news is mixed. President Trump’s plan for tax cuts and infrastructure spending looks delayed until 2018. His slim Senate majority means that stimulus is likely to be modest. Newly elected President Macron in France is promising fiscal restraint. By contrast, the UK’s conservative government is planning to ease back on fiscal austerity after nearly losing the recent general election.
  • Emerging markets exports remain robust, but there are tentative signs of a peak.

The indicators point to an easing of U.S. inflation pressures, a still modest boost from fiscal policy, and continuing strength in global trade.

Exports by selected EM countries

Source: Thomson Reuters Datastream, as of May 15, 2017.

Global equities: cycle, value, sentiment

Our investment process is based on the building blocks of cycle, value and sentiment.

  • Business cycle: It’s a mixed-cycle outlook for global equities. Cycle tailwinds for equities appear strongest in Europe, followed by emerging markets, and Japan. The U.S. cycle score is neutral. Economic growth is near trend and corporate earnings growth is limited by high margins and a lack of pricing power. Tax cuts and infrastructure spending could provide a fiscal policy boost, but if enacted, are likely to be offset by further Fed tightening.
  • Valuation: U.S. equities are very expensive. The Shiller P/E ratio, which uses the 10- year average of inflation-adjusted earnings, is the highest it’s been outside of 1929 and the late-1990s Internet bubble. European equities have moved to slightly expensive after their recent run. Japanese equities are around fair value, while emerging markets are still reasonably cheap.
  • Sentiment: Price momentum is positive across all regional markets, but a range of indicators still suggest markets are overbought and complacent. The most prominent contrarian indicator is the CBOE Volatility Index® (VIX®) otherwise known as the “fear index.” It has fallen to levels last seen in 2006.
  • Conclusion: We’re still cautious on the near-term outlook for global equities, with the expensive U.S. market the most vulnerable. Europe is slightly expensive after its recent run, but has good cycle support. Japan and emerging markets have some modest cyclical tailwinds, with EM having some valuation support as well.

Treasuries: The cycle has become more neutral

Government bonds are still expensive in all regions. They are closest to our fair value estimate in the U.S. and furthest from fair value in Germany and the UK.

The main change is that the cycle view for U.S. Treasuries has moved from negative to broadly neutral. Economic disappointment, the stalling in wage acceleration, and the lack of pricing power have generated some disinflationary forces in the U.S. economy that look likely to persist for the next few quarters.

Cyclical forces look broadly neutral in Japan and the eurozone. The Bank of Japan has recently reaffirmed its policy of targeting zero percent for the 10-year bond yield. The European Central Bank has signaled that it will continue with negative rates and asset purchases until at least the end of 2017.

The cycle is slightly negative for UK gilts, where the large post-Brexit referendum British pound sterling devaluation is pushing up inflation.

Our sentiment indicators are mostly neutral, save for the U.S. being slightly overbought after the recent rally. Broadly, our process points to yields remaining in a range for the next few months, but expensive valuation means the medium-term trend is upward.

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