Based on our growth and interest-rate forecasts, we remain bullish on stocks, particularly after the most recent correction.
A little bit more gratitude might have been appropriate. It's true that the March meeting of the Fed didn't offer any spectacular surprises and delivered just what many market observers had expected. Nonetheless, just as in recent years, the Fed provided investors with the stuff market rallies are made of: an economy that runs neither too hot nor too cold – the Goldilocks scenario. And this time Goldilocks got cream on her porridge: a little acceleration in growth without any tangible inflationary pressure.
The Fed raised its growth forecasts for the United States from 2.5% to 2.7% for 2018 and from 2.1% to 2.4% for 2019. It kept its forecast for inflation in 2018 at 1.9% and raised it to 2.1% for 2019. Thus everything is fine from an investor's perspective. The risk of overheating seems very small if growth is set to peak this year at 2.7% and cool a little next year. The expected pace of growth is neither too hot nor inflationary but on trend: the U.S. economy has grown by 2.5% on average over the past 25 years.
The Fed raised its growth forecasts for the United States from 2.5% to 2.7% for 2018 and from 2.1% to 2.4% for 2019. It kept its forecast for inflation in 2018 at 1.9% and raised it to 2.1% for 2019. Thus everything is fine from an investor's perspective. The risk of overheating seems very small if growth is set to peak this year at 2.7% and cool a little next year. The expected pace of growth is neither too hot nor inflationary but on trend: the U.S. economy has grown by 2.5% on average over the past 25 years.
Yet there was no gratitude, and markets continued their correction. Why? In our view, markets are nervous for a combination of reasons. First, due to their strong performance last year and extraordinary start to 2018, stock markets have reached valuation levels that react very sensitively to any slightly weak data point. An example of this, and therefore the second cause of stock-market nervousness, were the purchasing managers' indices, which in the first quarter remained at a high level but could not push higher, or actually declined, as they did in Europe and Japan. Third, there were growing signs by mid-March that Donald Trump might actually implement his protectionist plans. And fourth, the stimuli from the central banks are widely assumed to abate tangibly this year. Fifth, all of this is happening against the backdrop of rising U.S. interest rates.
This unsettling cocktail ended the unusually long phase of very low stock-market volatility. And the rise in volatility to more normal levels itself affected share valuations negatively by increasing the risk premium demanded by investors. At the same time, it allows active managers to take advantage of market fluctuations with portfolio shifts and adjustments in their cash holdings.
Our positions
We are largely maintaining our cyclical bias, though with some adjustments. From a tactical viewpoint, we have downgraded the materials sector to neutral and upgraded the real-estate sector to neutral. After a long phase of weakness, real estate is trading at a significant discount to the overall market. Investors tend to avoid bond-proxy sectors when interest rates are rising but our interest-rate forecasts are below those of the market. It would take a sharp rise in interest rates to harm stocks in general and high-dividend equities in particular. Although the latter tend to perform worse than cyclical stocks in an environment of rising interest rates, a look at U.S. market history shows that the increase in interest rates had to exceed 200 basis points within one year in order to drive dividend stocks into the red. Therefore we see yields of more than 3.5% on 10-year U.S. government bonds as a critical level. If yields stay below that, stocks should prove resilient. What's more, dividend-payers once again lived up to their defensive nature during the correction in mid-March and may therefore appeal to investors who want to be on the relatively safe side in a more volatile year.
In the materials sector, we are mainly concerned about elevated steel inventories and rising oil production. We continue to view the tech sector positively. Although it further increased its valuation premium by again outperforming the market in the first quarter, this was undermined by operating results. We do, however, recognize that particularly the larger tech companies are facing increasingly stringent and possibly expensive regulatory headwinds. A new stage appears to have been reached, with issues such as data security and privacy rights being discussed even in the United States.
At the same time, the increasingly protectionist rhetoric from the White House could potentially pose a challenge for export-oriented regions and sectors. The first attempts at implementation are already underway and this issue is likely to weigh on markets for some time to come. It is difficult to formulate realistic scenarios of what might happen as Trump's economic rationale cannot be deduced easily – especially as more and more U.S. companies are pointing out that they would rather not have this kind of support from the White House. Due to the lingering uncertainty, we have slightly reduced our index targets for Japan, Europe and Germany. However, given that in some cases these regions – like the emerging markets – enjoy record-high valuation discounts against the United States, we are keeping them at overweight and the United States at underweight. Putting the tech sector aside, these regions have already outperformed the U.S. market this year despite all the turbulence, in which they normally wobble more severely than the United States.
Stocks buoyed by small rate rises in the past
As interest rates usually rise due to increased growth, stocks often rise, too. But the threshold so far is 2 percentage points.
