There appears to be an inherent contradiction in U.S. real gross domestic product growth edging toward 4 percent while 30-year bond yields are below 3 percent. The U.S. economy is accelerating sharply and may be boosted further by the recent drop in oil prices.
This contradiction is at the very essence of the macroeconomic environment we face in 2015. Yet the U.S. is doing a poor job in exporting its recovery to the rest of the globe. By contrast, the U.S. is doing a great job in importing the rest of the worlds monetary policy. Weakness in commodities markets is symptomatic of chronic overcapacity and sluggish growth elsewhere in the world. This, in turn, is causing a powerful disinflationary impulse that is holding down long-end yields, even as the U.S. Federal Reserve looks to start hiking rates in 2015.
The upshot is a U.S. economy accelerating from an extended early cycle into a solid midcycle 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 some emerging markets, keeps long-end yields compressed. For economies such as the U.S. with domestic growth momentum, this creates a benign backdrop for equities. Elsewhere, for stocks to perform, central bank stimulus remains key.
We expect the flattening trends seen during the second half of 2014 to persist through 2015. In the U.S. we expect rising front-end rates increasingly to drive this trend. In Europe and Japan we expect to see a persistent bid for duration, even with ten-year Bunds and Japanese government bonds at 65 basis points and 35 basis points, respectively. In part this reflects our expectation at J.P. Morgan Asset Management for continued monetary easing but also our view that policy measures, at least in Europe, may fall some way short of what is needed to reverse deflationary fears.
We expect global overcapacity and stimulus to continue to hold down bond yields, at least for the early part of 2015. U.S. equities remain underpinned by an increasingly powerful recovery that will likely elicit Fed tightening later this year. Our conviction views are thus an overweight to U.S. equity, a modest overweight to duration expressed through U.S. yield curve flatteners and an overweight to Japanese stocks in which the Bank of Japan is all-in. By contrast, we are increasingly cautious on credit and emerging-markets debt, where the slump in oil prices will likely lead to higher default risk. We remain underweight commodities, U.K. and emerging-markets equity and the U.K. pound.
Our central 2015 themes are of a continued but gradual reacceleration of the U.S. economy, the start of Fed rate hikes and a rather uneven global growth that 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 of this view.
To the downside, overzealous Fed rate hikes could snuff out the nascent recovery and starve the world economy of liquidity. Equally, a currency-precipitated emerging-markets crisis or the failure of Japanese Prime Minister Shinzo Abes experiments with Abenomics could prompt a swift decline in risk appetite. We believe we are at the beginning of a dollar bull market, which historically has lasted seven to eight years. To the upside, a broadening out of the U.S. recovery around the world, a smooth and successful rebalancing in China or the permanent removal of 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 a great diversification. Bond yields may be compressed, but there is value in credit as a carry asset, and fixed income will always have a place in a balanced portfolio. U.K. equities will be weak, emerging markets are not cheap enough, and 6 percent return for institutional investors is the new 8 percent. Going forward, diversification across asset classes, duration and geographies needs to be the new norm.
John Bilton is head of the Global Strategy Team for the Investment Management Solutions Global Multi-Asset Group at J.P. Morgan Asset Management in London.
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