Q3 Global Market Outlook: Late-cycle lean out
What’s next for 2017? Russell Investments’ team of strategists provide their mid-year update and global market outlook for the third quarter.
Bond investors are from Mars and equity investors are from Venus
Bond investors are from Mars and equity investors are from Venus, or at least that’s what their current behaviour suggests. The unbridled optimism of record highs in the U.S. equity markets is in stark contrast to the sombre mood depicted by low and declining Treasury yields. How long will this last?
In this global market outlook, our team of investment strategists provide a half-year update and look at what’s next for markets in 2017.
Key market themes
U.S. equities continue to post record highs as the economy disappoints and bond yields decline. The market is vulnerable however, to either a recession scare or a rising interest rate scare. We believe both scenarios seem unlikely in the near-term and we maintain our “buy the dips and sell the rallies” mindset. We want to lighten up in the current rally and look to buy the next dip. Last week, we looked at how to make sense of current equity and bond pricing.
In the UK, Brexit negotiations have started. Uncertainty around what the UK government really wants, means risk around the final outcome has increased. This will likely be a source of future market volatility.
From a eurozone perspective, the past few months have seen the gap close between strong fundamentals and weak relative performance. In the medium-term, we expect the fundamental tailwind to continue to support eurozone markets. Pro-euro, pro-globalisation reform agenda could make the single European currency more appealing in the longer term.
We expect developing countries within the Asia-Pacific region to outperform through 2017, while the outlook for the developed countries (such as Japan and Australia) is far more mixed.
The Asia-Pacific region remains resilient, and we continue to expect GDP growth of around 5%.
—Graham Harman and Alex Cousley
Our three key indicators for 2017 are U.S. wage measures, fiscal policy announcements and emerging markets (EM) exports.
- U.S. wage growth has moved sideways this year, despite the unemployment rate declining to 4.3% in May.
- Fiscal policy is providing a modest boost to growth this year, but the recent news is mixed: President Trump’s plans look delayed, President Macron is promising fiscal restraint in France, while the UK government is planning to reduce fiscal austerity.
- Emerging markets exports remain robust, but there are tentative signs of a peak.
Together these indicators point to an easing of U.S. inflation pressures, a still modest boost from fiscal policy, and continuing strength in global trade.
Asset class views
Equities: Cautious on the near-term outlook
Cycle tailwinds for equities appear strongest in Europe, followed by emerging markets and Japan.
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.
The good news in Europe can continue.
Fixed income: Expensive valuations
Government bonds are still expensive in all regions. The cycle is slightly negative for UK gilts, where the large post-Brexit referendum British pound sterling devaluation is pushing up inflation. Cyclical forces look broadly neutral in the U.S., Japan and the eurozone.
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.
Government bonds are closest to our fair value estimate in the U.S. and furthest from fair value in Germany and the UK.
Currencies: European renaissance, sterling potential, greenback peak
We are becoming more constructive on the euro and the second half of the year could see a sustained rally. Other European currencies that usually correlate closely with the euro, such as the Swiss franc and the Swedish krona, could also benefit.
Following the UK general election in June, we may see a “softer” Brexit, which would be a positive for the pound and keep it within the 1.20 to 1.30 range to the U.S. dollar. Van Luu recently assessed scenarios for sterling and Brexit here. Sterling also enjoys favourable valuation vis-à-vis the U.S. currency, which could eventually push it beyond 1.30.
While interest rate differentials between the U.S. and the rest of the G10 countries are still supportive of the U.S. dollar, the greenback is also still expensively valued. All in all, we believe that the greenback is unlikely to revisit or exceed its previous highs in the second half of 2017.
Read more about how to manage currency risks and opportunities.
Global Market Outlook Conclusion
Today we find ourselves in a late-cycle, momentum-driven market, where valuation is at an extreme, most notably in the U.S. Bond markets and equity markets are pricing in opposite interpretations of the world. The two will eventually reconcile, but it’s possible that these contradictory views will persist for a while longer. We’re more inclined to side with the bond market than the equity market at this late stage of the cycle. No investment process is going to pick the peak in the cycle so we are looking to lean out as the risks increase.
As we look ahead to the second half of 2017, like Paul McCartney’s lyrics, we’re sitting in the stand waiting for the show to begin when Venus and Mars align again.