Investment strategy outlook
Moderate growth, low inflation and easy monetary policy appear to provide a positive backdrop for investment portfolios as we look toward the fourth quarter of 2017. We still want to buy dips and sell rallies. Expensive U.S. equity valuation remains our main concern. Cyclical forces are moving in favor of higher government bond yields. We believe the euro has upside and that the U.S. dollar's (USD) downtrend should be arrested by early 2018.
Momentum versus asymmetry
Developed economies are in the “sweet spot” of moderately above-trend growth, continuing low inflation and easy monetary policy — or in the case of the U.S. Federal Reserve (the Fed), very gradual tightening. It’s a supportive environment for just about every part of a portfolio. Over the third quarter of 2017, equity markets have drifted higher globally, corporate credit and real assets have gained and government bonds have rallied.
Two words that keep recurring in our strategist team discussions are “momentum” and “asymmetry.” A benign economic environment can see markets trend higher. We capture this in the “sentiment” part of our cycle, value and sentiment (CVS) investment decision-making process. Our equity cycle scores are mostly neutral to slightly positive.
It’s the “value” part of our process that creates asymmetry concerns. U.S. equities are extremely expensive, making the market vulnerable to any news that upsets the industry consensus on moderate growth, low inflation and low interest rates.
The two big risks in our view are either a recession scare or an inflation scare that sends interest rate expectations significantly higher. Both seem unlikely in the near term, although we believe fixed income markets seem to be underestimating the potential for U.S. inflation pressures and Fed rate hikes in 2018.
Another worry is the potential for a sharp spike in volatility. The low level of the CBOE Volatility Index® (VIX Index) underlines the degree of investor complacency. The issues that could cause a volatility spike are hard to predict, but an obvious current candidate is the tension around North Korea.
Our CVS 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.
Within fixed income, we like local currency emerging markets debt from both a value and cycle perspective. We’re slightly underweight high-yield credit because of expensive valuation against a broadly neutral cycle outlook. We’re also slightly underweight global government bonds. Fed tightening and likely European Central Bank (ECB) tapering are negatives for the cycle view, while regional bond market valuation in late September 2017 ranges from slightly expensive in the U.S. to very expensive in Germany.We’re still in a “buy the dips and sell the rallies” market environment. This will continue while our equity cycle scores remain neutral to positive. We will look to the overbought/oversold indicators from our sentiment process to help guide us in buying dips and selling rallies.
It’s the elevated level of the cyclically adjusted price earnings ratio (CAPE) that makes us nervous about asymmetry – that the downside for S&P 500® Index returns is larger than the upside. The CAPE divides the current level of the S&P 500 by the 10-year average of inflation-adjusted earnings per share. In other words, it compares the current level of the equity market with the “normal” level of earnings. Traditional price/earnings (P/E) ratios can be misleading, showing the market as artificially cheap when earnings are cyclically high (as they are at the end of the third quarter of 2017) and expensive when earnings are temporarily depressed.
Shiller P/E ratio: rolling 10-year trends since 1880
Source: Economist Robert J. Shiller, last observation September 8, 2017
Blue line shows average P/E of 14.3 for the entire time frame.
Thanks to economist Robert Shiller, we have a history of the S&P 500 CAPE back to 1880. It currently stands at just over 30-times trend earnings, a level reached only twice before; during the tech bubble of the late 1990s and in the 1929 market boom.
A high CAPE means that future returns are likely to be disappointing. The average annualized return over the following three years when the CAPE has been above 22-times earnings trends is less than 5%.
It also increases drawdown risk dramatically. The average drawdown over the following three years when the CAPE has been above 22-times is around -21%. We passed the 22-times mark four years ago, so this episode is already an outlier. Asymmetry will remain a significant concern.
Government bonds: Cycle & value point to rising yields
Government bonds are expensive in all regions as the third quarter ends. U.S. 10-year Treasuries at around 2.2% are closest to our fair value estimate of 2.7%. German 10-year Bunds at 0.4% are some way from fair value of 1.5%, as are UK 10-year Gilts at a yield of 1.4% and fair value of 2.4%.
The cycle is moving in favor of higher yields. ECB tapering of bond purchases in 2018 will put upward pressure on the term premium, as will the Fed’s plans to slowly reduce its holdings of Treasuries.
The surprise has been low inflation in the U.S., where core inflation was just 1.7% in July 2017. We believe this should start to pick up in coming months. The U.S. unemployment rate has been below 4.5% since March and many indicators show that the economy is near full capacity. The 10% decline in the U.S. Dollar Index (DXY) this year should also start to show up in import price inflation.
Interest rate markets are pricing in less than one Fed rate hike until the end of 2018, but we think two to three rate rises are likely given the inflation backdrop.
Sentiment is turning negative for government bond markets with the recent rally triggering overbought signals.
Expensive valuation plus a more negative cycle outlook has our process pointing to a modest upward trend in global yields over the next 12 months.
Currency: Euro still has upside
The story of 2017 so far has been the weakness in the U.S. dollar (USD) and strength in the euro. We expect euro strength to continue. Our CVS process marks the euro as around 10% undervalued at the end of the third quarter. The cycle is turning more favorable as the economy picks up, the ECB winds down quantitative easing (QE) and political risks subside. The next Italian general election due in early 2018 is looking less ominous with toned-down anti-euro political rhetoric following the failure of populist political messages in the recent Dutch, French and German elections.
Sentiment is a tailwind for the euro as it has solid upward momentum, but it remains tempered by some overbought signs. The ECB is the main factor standing in the way of further euro strength. It could start warning about the disinflationary impact of euro appreciation and potentially delay the tapering of QE should the euro rise too quickly. Even so, we think the euro still has some upside.
The USD, in contrast, is expensive even after falling 10% in trade-weighted terms this year. The USD is in a downward trend, and this could continue for a few more months if weak inflation keeps Fed policy unchanged through December.
The cycle is likely to turn more dollar positive in 2018 if, as we expect, the Fed signals more aggressive tightening intentions than investors currently expect. A potential USD turning point in early 2018 is one of our key watch-points.