We expect global economic growth to remain robust, with headline inflation rising only gradually. Still, given this past year’s strong gains in equity prices and the slump in volatility, we think it's prudent to limit risk exposure and temporarily raise cash reserves.
That said, we continue to overweigh equities. In currencies, we shift back modestly in favor of the US dollar.
In this report we present our macro assessment and asset allocation for the next three to six months. The decisions concern LGT Capital Partners’ multi-asset strategies.
Our base scenario remains broadly unchanged: we have globally synchronized economic growth with subdued inflation, and the data is pointing to continuity going into 2018. For example, the recent US purchasing manager index (PMI) readings, which tend to lead gross domestic product (GDP), foretell a growth rebound to historically average levels of 3-3.5% (graph 1). The international PMIs keep pointing in the same direction as well (graph 2), with the developed economies maintaining a lead over the emerging ones (in terms of relative momentum). At the same time, inflation readings have partly started to recover, but generally remain below target (graph 3).
Meanwhile, the monetary policy settings now seem well-calibrated in most major economies. Hence, inflationary concerns due to an overheating economy remain as unwarranted as disinflationary fears that could lead us into a recession.
That said, if growth dynamics accelerate further from here, there is a risk of (some) major central banks responding too aggressively, i.e. by bringing forward or intensifying their tightening paths.
We thus also keep our alternative scenario of a disinflationary slowdown in economic growth, although we continue to attribute a low probability to its occurrence.
Thus far, the US Federal Reserve has been treading cautiously when it comes to its tightening path. Still, by international comparison, it appears somewhat more inclined to accelerate the pace of rate hikes beyond what’s currently anticipated - particularly if congress passes tax reform in the coming weeks. New policy biases could also be telegraphed more clearly this coming spring - i.e. after Jerome Powell formally takes over the Fed’s board of directors from Janet Yellen.
After all, the US economy is closest to hitting the 2% annual inflation goal over the medium term, with the core inflation rate being a good indicator of medium-term inflation trends. By comparison, the European Central Bank and the Bank of Japan are more likely to extend their current policy biases, given that their economies are both still further away from their targets (graph 3).
Lastly, the geopolitical and political risks remain well-contained - at least in the sense that the “know unknowns” are unlikely to derail global economic growth in the near term in our view. Hence, the backdrop for risk assets remains generally good.
At the same time, we are increasingly observing some late-cycle phenomena. For instance, sentiment indicators point to elevated optimism, while industry surveys show that most institutional investors are “uncomfortably long” - i.e. participants are overweight risk assets, while at the same acknowledging that such risk-taking is no longer appropriately rewarded (equity valuations are perceived as elevated, credit spreads are very low by historical standards, etc.). There are also signs of emerging exuberance, such as the hype surrounding cryptocurrencies or the surge in the so-called short-volatility carry-trades¹.
Of course, here we must note that periods leading up to market euphoria phases tend to deliver some of the highest returns - and can last for years (chart 4). This fact, combined with our positive underlying assessment of economic fundamentals, naturally compels to generally keep the equity overweight in our diversified portfolios. However, the strategy team has also deemed it prudent to temporarily raise cash reserves, which would allow us to opportunistically redeploy capital in markets during sentiment-driven corrections, if and when they occur (read more in the LGT Beacon).
Note: The next edition of the LGT Beacon is scheduled for mid January 2018.