Global momentum slows as Trumphoria wanes 
We expect global economic momentum to slow in the second half of the year and reflation expectations to wane. Our global economic momentum indicator shows the first signs of slowing. This is mainly driven by China, where the central bank is beginning to tighten in order to limit leverage risks. Europe, on the other hand, should continue to do relatively well in growth terms. Also, it has the advantage of having the most dovish of the G3 pack (dollar, euro and yen).
For the US, we do not expect a growth acceleration in the second half, as real disposable income is not growing strong enough to drive consumption growth higher on a sustained basis. At the same time, corporate investments are still not taking off, as Trumphoria is waning and scepticism around tax cuts, et cetera is growing. The US continues to be in a ‘wait and see’ mode.
Expect growth to disappoint in the second half
Despite tightening signals from major central banks and stellar equity performance year-to-date, based on hopes for higher growth, rates are still relatively low, especially in the long end of the curve. Despite the recent wobbles, 10-year US government bond yields are down this year.
At the same time, the interest rate curve has flattened since the start of the year in most of the biggest bond markets, normally signalling a weaker economic outlook. Lastly, fixed income market based inflation expectations are also down since the beginning of the year, contradicting the hawkish rhetoric of central banks as of late. So what is right – equities or bonds?
We think the latter is right. As we expect growth to disappoint in the second half and headline inflation to fall or stay weak this should also support core government bonds, especially the US.
So yields are unlikely to break out of this year’s trading ranges and even have the potential to fall further as we approach year end, although only moderately due to already low yield levels. Bond markets are apparently sharing our sceptical view on growth and inflation, hence the decent government bond returns this year, despite the recent sell-off.
Selection is vital within emerging markets
We are neutral on emerging market equities and more positive on emerging market bonds. But differentiation is key in the emerging market universe. As we expect China to slow in the second half of the year, we would prefer countries with limited China and commodity exposure. In this context, Indian equities seem attractive.
On the bond side, we prefer hard currency debt, as the US dollar is expected to strengthen – although only moderately so – again later in 2017. If the US economy is so weak that the Fed becomes more dovish and Goldilocks prevails, not too hot and not too cold, we would change this view.
Expect the equity rally to lose steam
We see three challenges towards a continuation of the ‘bull run’ in equities. Firstly, peak reflation/ weaker commodities are expected to hurt companies earnings growth further down the road and we are likely to see downward revisions of earnings estimates and disappointments. Secondly, implicit growth expectations derived from risk assets prices are very high and disappointments are increasingly likely in the second half as growth in China is slowing down and Trump’s tax plans may be delayed – or even derailed.
Finally, monetary conditions are becoming a headwind, with G3 central banks tightening and possibly even reversing unconventional stimulus as the Fed is preparing a balance sheet reduction. This is a big wild card, as we enter unchartered territory. Therefore, we expect the rally in equities to lose steam in the second half and volatility to rise.
Look to core fixed income towards year end
Short term, we are neutral on equities and bonds. Towards year end, we would prefer core fixed income relative to equities given the points mentioned above. In an environment where central banks are tightening, equities need new drivers. With the growth and inflation outlook outlined above, these are unlikely to emerge in the near future.
Nevertheless, it makes sense to have cash proxies in your portfolio – like short duration bonds – as we have been in a Goldilocks environment in the first half. All boats have been being lifted by benign monetary conditions, as well as a weak US dollar. The real risk to this ‘buy-everything’ scenario is a ‘sell-everything’ scenario, as central bank tightening broadens and gathers pace. A wall of liquidity has supported risk assets since the Global Financial Crisis. If the Fed was to stop reinvesting its maturing bonds and thereby reduce its balance sheet, this would mean an adverse liquidity shock, limiting the support for especially risk assets. In this case, cash proxies would be one of the few places to hide. That said, this is only a risk scenario.
Witold Bahrke is senior macro strategist at Nordea Asset Management. The views expressed above are his own and should not be taken as investment advice.