By John Bilton
There appears to be an inherent contradiction in U.S. real Gross Domestic Product (GDP) growth edging towards 4% while 30-year bond yields are below 3%. But this is the very essence of the macroeconomic environment we face in 2015. The U.S. economy is accelerating sharply and may be boosted further by the recent drop in the oil price.
Yet America is doing a poor job in exporting its recovery to the rest of the globe. By contrast, the US is doing a great job in importing the rest of the world’s monetary policy. Weakness in commodity markets is symptomatic of chronic overcapacity and sclerotic growth elsewhere in the world. This in turn is causing a powerful disinflationary impulse which is holding down long-end yields, even as the US Federal Reserve (Fed) looks to start hiking rates in 2015.
The upshot is a US economy accelerating from an extended early cycle into a solid mid-cycle phase but with the business cycle elsewhere struggling to pick up. Divergent growth leads to divergent policy which, in combination with the disinflationary pressure coming from Europe and parts of the emerging markets, keeps long-end yields compressed. For economies with domestic growth momentum, such as the US, this creates a benign backdrop for equities. Elsewhere, for stocks to perform, central bank stimulus remains key.
We expect the flattening trends of 2H14 to persist through 2015. In the US we expect rising front-end rates increasingly to drive this trend. Meanwhile in Europe and Japan we expect to see a persistent bid for duration, even with 10-year Bunds and Japanese government bonds at 65 bps and 35 bps, respectively. In part this reflects our expectations for continued monetary easing, but also our view that policy measures, at least in Europe, may fall some way short off what is needed to reverse deflationary fears.
As we enter 2015, we expect global overcapacity and stimulus to continue to hold down bond yields. Meanwhile, US equities remain underpinned by an increasingly powerful recovery that will likely elicit a Fed tightening later in 2015. Our conviction views are thus an overweight to US equity, a modest overweight to duration expressed through US yield curve flatteners, and an overweight to Japanese stocks where the Bank of Japan is “all-in.” By contrast, we are increasingly cautious on credit and emerging market (EM) debt, where the ravages of the move in oil will likely lead to higher default risk. We remain underweight commodities, UK and EM equity, and pound sterling.
Our central 2015 themes are of a continued but gradual re-acceleration of the US economy, the start of Fed rate hikes, and rather uneven global growth will combine in the manifestation of a longer but flatter business cycle. Our asset allocation views are governed by this economic thesis but we are mindful of the risks to this view.
To the downside, an over-zealous pace of Fed rate hikes could snuff out the nascent recovery and starve the world economy of liquidity. Equally a currency precipitated EM crisis, or the failure of Japan’s “Abenomics” experiment could prompt a swift decline in risk appetite. We believe we are the beginning of a dollar bull market, which have historically lasted seven to eight years.
Meanwhile to the upside, a broadening out of the US recovery around the world, a smooth and successful rebalancing in China, or permanent removal of the “secular stagnation” risks would likely mean a sharp increase in risk appetite.
So what does this mean for investors – simply put, this is not a great rotation but the great diversification. Bond yields may be compressed, but there is value in credit as a carry asset, and bonds will always have a place in a balanced portfolio. UK equities will be weak, emerging markets is not cheap enough and 6% return for institutional investors is the new 8%. Going forward diversification across asset classes, duration and geographies needs to be the new norm.
John Bilton is a global strategist at JP Morgan Asset Management
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