More Turbulence Expected As we are getting to the end of the Fed tightening cycle, we are expecting more turbulence. In this last quarter we have seen how equity and fixed income assets gyrate as the market changes its mind on when the Fed will finally pause. Have they been too loose and allowed the economy to grow too fast? Or have they tightened so much that the economy might fall into recession? Typically the equity markets want rate hikes to stop, as they are worried that Fed will tighten too far and the economy will collapse. But the bond markets want monetary discipline in order to avoid inflation.
Growth is a Global Phenomenon High-risk assets, such as emerging markets, have surged over the last three years on excess liquidity and robust global economic growth. Therefore, many assume that if the US slows they will have to crash. Current policy uncertainty has indeed raised volatility, but we are less concerned. Growth is a global phenomenon, with the IMF forecasting the fourth year of more than 4% global GDP growth. Although the US has led the recovery, there are signs that the rest of the world is picking up the pace. Japanese employment is rising and domestic demand is growing. European purchasing manager and consumer surveys show continued confidence as employment grows. There are signs that China is developing a consumer class. Despite commodity price pressures, inflation is subdued around the world due to globalization and the Chinese industrial machine.
US Consumers US consumers in aggregate are healthy with rising wealth and incomes. There is a widening dispersion, with certain segments of the population getting pinched by rising interest rates on ARMS, which will cause pain and bankruptcies for some. But unemployment has dropped to 4.6%. The jobs data is mixed, with recent readings of non-farm payrolls missing expectations, but we pay more attention to the establishment survey and ADP (after all, this company that processes a huge share of US paychecks should draw more reliable conclusions than a government sample survey). We do not want to bet against the US consumers' ability to continue spending.
Expect Short Rates to Continue Up We, therefore, think that US data will continue to come in too firm for the Fed to stop, and so short rates are likely to continue up. We still think that as the bond market sees the rising short end, it will sell off and keep the curve flat to upward sloping for a while longer, with 10-year yields peaking somewhere between 5.25% and 5.5%. This means that bonds will continue to underperform cash. US bond investors will earn around 5% over the next twelve months, with slightly less for high yield.
US Large Cap With this in mind, we expect US large cap to return around 7% over the next twelve months, outperforming small cap slightly. We expect non-US stocks to deliver around 8% before currency effects, with no significant differences between regions. This is because overseas markets are cheaper, have continued earnings growth, and will be boosted by bond yields remaining low.
Emerging Markets Emerging markets will be buffeted, but will be a good investment for the patient investor. Companies are achieving unusually good return on equity. Valuation metrics have deteriorated a little, but we expect earnings to continue to grow. Many countries are running budget and trade surpluses, with growing foreign reserves. We think they will perform in line with developed markets over the next year, with greater volatility.
Risks At this point in an economic expansion, there are plenty of things to be concerned with and to watch carefully.
Not Enough Fear Our biggest worry is that there is still not enough fear, although the May sell-off helped. Spreads of risky assets are all too low, whether that is corporate bonds, high yield or emerging market debt. Many investors are highly leveraged and assume that liquid markets will let them get out of losing positions – despite some being caught in May.
Deterioration of US Consumer Spending But the main risk to our view is a sudden deterioration of US consumer spending, perhaps driven by a shock to the system. If bonds or the dollar sell off rapidly, confidence could decline and lead to slowdown or contraction in the economy. Not only would this put pressure on the US markets and economy, but it would also ripple around the globe, affecting the fragile recoveries in Japan and Europe, as well as slowing growth in China.
Conclusion Although we started by asking you to fasten your seatbelts, we believe markets will continue to deliver decent returns to the patient investor. We expect that markets will move upwards in a zigzag fashion, giving opportunities to add value tactically. We encourage our clients to ensure that their portfolios are well diversified, especially into international markets.
Alistair Lowe is Head of Global Asset Allocation and Currency at State Street Global Advisors