The world economy and financial markets are progressing through the later stage of the business cycle. Synchronized global economic growth, coupled with low inflation and favourable
financial conditions are powerful drivers of corporate earnings, and hence equity prices.
How long will this favourable environment last? That is the key question at the crux of GLC’s 2018 Capital Market Outlook. There are few easy answers, and timing is always tricky.
Today, investor, business and consumer optimism is high. Yet as a natural progression, the further along the economy rolls the harder it becomes for conditions to improve. Eventually a
normal slowing of the economy is healthy and to be expected. We are closer to the end of the expansion cycle than the beginning and we see the relative outcomes for asset classes subject to greater uncertainty.
Our base case for GLC’s 2018 Capital Market Outlook is that the global economy has enough momentum, and that inflation and financial conditions will remain accommodative long enough, that we continue to favour equities over fixed income. Within that outlook, we acknowledge the attractiveness of equities over bonds on a risk-adjusted basis has narrowed. In short, we are less optimistic about the return prospects for equities, and similarly, less pessimistic about fixed income today than we were six months or a year ago.
At the current pace, we see supportive conditions lasting long enough that we believe it is too soon to move to a neutral stance, but caution is warranted, and we need to be nimble in our investment positioning.
It is precisely at times like these that investors need to strike a balance. Now is not the time to become aggressive, rather investors should remain disciplined, striking a balanced approach as they look toward, and prepare for, a time when the prevailing narrative is less rosy. Rebalancing out of equities that are scaling to new heights, and allocating into fixed income assets that appear less attractive is difficult. We recognize that globally, equities are not cheap, but the fundamentals remain solid enough that we see equities offering a modest degree of further upside potential.
We also recognize that the outlook for fixed income remains challenging. Yet fixed income remains a valuable risk mitigatingtool that increases in value the closer we get to the end of this business cycle phase. At this stage of the cycle, we believe it is prudent to reduce equity overweight positions and increase fixed income to less underweight positions.
The result strikes a balance - a tempered risk-on position with a slight overweight in equities.
GLC Outlook Summary
To see how GLC’s view of each sector has changed, please download the attached PDF reports at the bottom of this article.
Fixed income investors face a sideways market as slowly rising (normalizing) yields grind against the time required for higher coupons to make a positive contribution. Active management to navigate the yield curve and pick-up additional yield through credit instruments (provincials and IG corporates) does provide the opportunity for very low single digit positive gross returns.
With low and rising yields, government bonds offer little upside. Their value as a risk mitigation tool has risen and continues to rise the further along in the cycle we go.
Investment grade corporate bonds
We see investment grade corporate bonds as most attractive given their mix of yield pick-up and modest safety. We expect investment grade corporate bonds to outperform governments. Spreads have limited room for further tightening. Their generally shorter duration and higher running yield is a benefit in a rising rate environment.
High-yield corporate bonds
High-yield spreads have moved down, we see very limited room for further tightening. Given the very narrow spread levels and their lack of risk-mitigation characteristics, we see the risk/reward trade-off in high yield becoming unattractive.
We maintain our slight overweight in equities. We believe that the global economy has enough momentum, and that inflation and financial conditions will remain accommodative long enough, that our outlook continues to favour equities over fixed income. Equity valuations are elevated, reflecting our modest return forecasts.
Canada is our favoured market due to its greater sector leverage to global growth and firming commodity prices. Canada’s valuations are more reasonable than their global peers.
Our outlook for US equities is neutral, with returns in the low single digits as valuations are elevated. There remains a great deal of uncertainty due to potential policy changes. Fortunately, we assess the risk to be skewed to the upside vs. the downside on potential policy impacts.
We believe Europe (ex UK) offers the best risk-adjusted return of the EAFE markets. Eurozone equities offer a reasonable earnings growth outlook with relatively cheaper valuations, and stand to benefit from easier financial conditions for longer. We hold a neutral view on Japan.
Emerging markets offer the greatest upside potential with high earnings growth estimates and less expensive valuations, but come with the highest potential risks. This asset class by nature is complex and for the risk tolerant investor.
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This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.