General market overview
In March, investors showed signs of being unnerved, and almost ungrateful. This was despite the rather unspectacular March meeting of the U.S. Federal Reserve (the Fed). The outlook of the world's most influential central bank was closely in line with what investors have gotten used to in recent years.
The kind of Goldilocks scenario that, for much of this cycle, has consistently delivered returns of the sort investors can usually only dream of.
According to the Fed, the economy should continue to grow, but not overheat. Growth might even accelerate a little further, but without inflationary pressures picking up significantly.
In line with this scenario, the Fed increased its economic-growth projections from 2.5% to 2.7% in 2018 and from 2.1% to 2.4% in 2019. It left its inflation forecast at 1.9% for 2018, but raised it to 2.1% for 2019. For investors, this all looks rather reassuring. After all, U.S. economic growth has averaged 2.5% over the past 25 years. So, it seems plausible enough that growth might peak at 2.7% this year, without triggering overheating.
If you were expecting grateful market applause, you were in for a disappointment, though. Instead, markets resumed their slump. Why? In our view, a number of factors are responsible for recent market nervousness. First, the rise in equity markets last year and at the beginning of this year had left equity valuations rather stretched. In such an environment, even the odd disappointing data point can be quite damaging. Such as, secondly, the Purchasing Manager indices (PMIs). In the first quarter, PMIs either stopped advancing further from their elevated levels, or declined, as they did in Japan and much of Europe. A third factor relates to the protectionist plans of U.S. President Donald Trump. March brought the first clear signs that this threat was getting serious. And fifth, all of this happened against the backdrop of rising U.S. yields.
However, yields are mostly only rising at the very short end and only in the U.S. In itself, this is also a sign of market nervousness. At the long end, there were actually slight yield declines in March. As a result, the U.S. yield curve flattened. The gap between yields on 2-year vs. 10-year U.S. Treasuries reached multi-year lows of 0.49%. The last time it was that low was in 2007. Moreover, some of the strongest performers in U.S. equities have lately been among the weaker ones. For the first time since 2016, the Nasdaq actually performed worse than the S&P 500.
Outlook and changes
Our quarterly CIO Day took place at the end of March. As a result, we have adjusted not just our tactical signals, but also our strategic forecasts. We remain positive, mainly based on our solid economic outlook. For the world economy as a whole, we expect 3.9% growth both this year and next year. We only expect moderate interest-rate increases. As a result, we continue to view equities and bonds offering a yield premium positively.Specifically, our positioning in equities remains largely pro-cyclical, with a few minor adjustments. For example, we have downgraded the materials sector and upgraded the real-estate sector, both now at neutral. The reason behind upgrading the real-estate sector is its long underperformance and the discount compared to the rest of the market based on historic average valuation measures, now looks larger than justified. Of course, all sectors where dividend yields make up a large part of total performance tend to struggle at times of rising interest rates. However, we view the likely increases in yields as too small to cause dividend stocks to decline in value on a 12-month basis. During recent periods of market turbulence, dividend stocks once again demonstrated their defensive characteristics. With a volatile year ahead, they may offer a safety buffer for investors wanting only limited risk exposure.
In the materials sector, our concerns mainly center around high levels of steel inventory and rising oil production. We continue to view the technology sector positively. For the first quarter as a whole, it has once again outperformed the broader market. Admittedly, this has also increased its valuation premium. However, this is underpinned by strong underlying performance data. While the technology sector may face some regulatory headwinds, we think it should remain among the better performers.
On a regional basis, we have slightly increased our equity index targets for the United States and emerging markets. These were last formulated at the end of February for the year-end 2018; the current ones are for the next 12 months, i.e. March 2019. For Europe, Germany and Japan, we have slightly cut our equity index targets. However, we continue to favor Europe, emerging markets and Japan on valuation grounds and have also overweighted Germany.
For bonds and currencies, we have slightly increased our strategic yield forecast. In particular, we see yields on 10-year U.S. Treasuries at 3.25% on a 12-month basis, compared to 3% previously. However, the increase is slightly larger for 2-year U.S. Treasuries, suggesting a further minor flatting of the yield curve. We do not expect to see a selloff in sovereign bonds such as U.S. Treasuries. Our favorites remain the Eurozone periphery, corporate bonds and emerging-market bonds.
As for currencies, we are expecting the dollar to strengthen in our strategic outlook. However, we are tactically neutral on all major currencies for the time being. This is because we are expecting important tactical signals in coming weeks, and want to be able to react in a timely fashion.
Also tactically, we have gone to underweight in UK sovereign bonds, because we might see some further upward pressure in yield. For corporate bonds from Asia, we are becoming more cautious, because there could be outflows due to U.S. protectionist rhetoric and the recent strengthening in the dollar.
