Global growth is expected to hit its fastest rate in seven years rising by nearly 4 per cent in 2018, according to asset allocators at Aviva Investors.
Growth is expected to be mainly driven by an upward revision in the outlook for the US, although prospects for the UK, eurozone, Japan and Canada are also modestly higher for the remainder of the year.
In its house view 2018 Q2 outlook, the investment strategy team who produce the document said: “In our 2018 outlook we described our growth expectations for this year as being robust.
“Three months on, the fundamentals continue to point to a year of strong global growth, with fiscal stimulus in the US adding to the growth dynamic.”
Indeed, the main change in the growth outlook for this year comes from an upward revision to the US, with more modest changes elsewhere, as the below chart shows.
Global growth revisions for 2018
Source: Aviva Investors
However, with growth expected to remain well above trend in all major economies in 2018, labour markets should continue to tighten as spare capacity is eroded, pushing inflation in advanced economies to around 2 per cent this year.
Given this combination, they expect central banks to continue their monetary tightening program as the era of cheap money draws to a close.
The investment strategy team noted: “We expect that the shift to tighter monetary policy will be a key market theme in 2018, resulting in more volatility across asset classes, particularly as risk premia are re-priced to better reflect fundamentals.
“The expected tightening in monetary policy reflects our positive global growth outlook and our expectation that the rise in inflation to central bank targets will be sustained.”
Investors should be aware of risks to this, however, with the potential for a trade war between the US and China a significant concern.
Outside of trade tensions, the team said that the market continues to under-price the risk of central banks moving away from the post-crisis trend of slow and gradual normalisation to something more active – particularly in the US.
“Alongside the prospect of rising rates globally, there are a range of countries and sectors that are highly leveraged and could become more challenged in that environment,” they said.
So what does this all mean from an asset allocation perspective?
At the start of the year, this combination of factors was global equities markets sell off as volatility returned and this means there is now an increased market risk.
Performance of index over YTD
Source: FE Analytics
The investment strategy team said: “We recognise the increased market risk – particularly given the magnitude of either explicit of implicit volatility selling products that have built up recent years and as such, we have modestly downgraded our expectations for equity markets this year.”
However, they remain constructive on the asset class in general and are particularly high on global risk assets due to strong economic fundamentals and a positive earnings outlook.
Conversely, they expect risk-free assets such as bond proxies to underperform as strong global growth, tightening labour markets, steadily rising inflation and the removal of monetary policy accommodation, have meant yields have continued to move higher, suggesting that duration will remain challenged through 2018.
As such, the team have moved from an underweight position in the US to a more neutral asset allocation, as they expect earnings growth to remain strong, with share buy-backs potentially giving more support to the market
“As a result, we have rebalanced our exposure in other markets and reducing slightly our European and Japanese exposure,” they said.
“This is because one potential headwind for both these markets going forward could be the currency, as the environment in terms of monetary policy is supportive for both the euro and the Japanese yen.”
The firm remains underweight UK equities as uncertainty around Brexit still makes the risk-reward balance unattractive.
But the team’s preferred area is the emerging markets which they are constructive on both in terms of equities as well as in the fixed income space.
“While global markets are still climbing a wall of worry – the most recent contributor being the trade policy initiatives coming out of the White House – the longer-term anchor of our central scenario is a world of strong growth and modest inflation pressures,” they said.
“Markets are taking more steps towards normalisation as we slowly exit from the decade-long experience of experimental monetary policy.
“The euro and yen currencies are likely to take the baton from the US dollar as appreciating currencies.”
Performance of index over 5yrs
Source: FE Analytics
This favours taking exposure in emerging markets as when the dollar weakens, companies paying their debt in the US currency have lower repayments.
This, combined with strong growth and still supportive valuations, means that emerging market assets continue to look attractive.
Finally, turning to fixed income, investors should look to avoid duration, which is the key element in the firm’s asset allocation decision making for the asset class.
“We think duration should be an aggressive underweight both in the sovereign and credit space in most developed markets,” the investment strategy team said.
“The most acute threats for duration lie in Japan and the eurozone for sovereign bonds, while we see US Treasuries as neutral at best.”
One area they have become more constructive on however is hard currency emerging market debt which has moved from underweight to neutral.
“We still prefer local currency debt to hard currency debt on valuation grounds, however as we reduce exposure further in developed market fixed income, we upgrade hard currency debt from underweight to neutral,” they said.