Leading indicators of global growth momentum continue to decelerate across regions, particularly in Europe and Asia, where business surveys in manufacturing and service industries indicate growth rates have likely peaked for now.
This message also seems confirmed by the evolution of earnings expectations, with revision ratios peaking both in the United States and Europe (Exhibit 1), suggesting that despite broad-based positive earnings surprises in the first quarter of 2018, growth rates are expected to decelerate but remain comfortably positive.1
Among the major regions, U.S. growth is still showing positive momentum, compared with other countries, and is supported by strong labor market gains and fiscal expansion.
Overall, our macro regime framework is unchanged versus last month. The global economy continues to slow (with growth above trend, but decelerating), driven by decelerations in international markets, while the United States remains in an expansion (with growth above trend and accelerating). Similarly, global market sentiment has seen a further downshift in the past few weeks, providing additional confirmation of slowing economic momentum (Exhibit 2).
As we have described in the past, we believe the current macro environment is somewhat neutral from an asset allocation standpoint and, on average, there is little compensation for tilting towards riskier assets, especially in risk-adjusted terms. Hence we maintain a neutral equity allocation in line with our 60% equity/40% fixed income benchmark, coupled with a duration underweight in developed markets.
Strong Dollar Headwind for Emerging Markets
The main beneficiary of growth deceleration in international markets has been the U.S. dollar, which has appreciated against most currencies in both developed and emerging markets (EM). The rebound in the greenback has caused some near-term headwinds for EM assets, which have underperformed their developed markets counterparts across equities and fixed income.
However, most of the underperformance year-to-date has come from the currency component rather than local equities or fixed income. This is a typical occurrence, where short-term corrections are often dominated by currency weakness as global investors hedge currency risk in a timely manner while holding on to the less-liquid underlying investments, especially when those investments are supported by strong fundamentals, as is the case today.
Despite the recent deceleration in growth indicators, we remain overweight emerging market equities and local debt versus developed markets, given low and falling inflation, negative inflation surprises, above-trend growth, and improving current account balances. (Exhibit 3)
Similarly, we see the recent dollar rally as a correction within a medium-term depreciation trend, fueled by rising U.S. fiscal and external deficits and moderately expensive valuations. Among alternative asset classes, we remain overweight Brent oil (via futures), as inventories continue to tighten despite increasing U.S. production, reflecting strong global demand.
Finally, we are overweight catastrophe bonds at the expense of investment-grade credit, given attractive expected loss-adjusted yields and the potential for increased diversification benefits in a mature credit cycle.
- ^Revision ratios are defined as the net percent of positive revisions in 12-month forward earnings over the past 3 months.
Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall. Emerging and developing market investments may especially be volatile. Event-linked securities otherwise known as Cat Bonds are fixed income securities for which the return of principal and interest payment is contingent on the non-occurrence of a trigger event that leads to physical or economic loss. If the trigger event occurs prior to maturity, event-linked securities may lose all or a portion of its principal and additional interest. Diversification does not guarantee profit or protect against loss.