Markets & Economy
2017 Outlook: Global Asset AllocationJanuary 13, 2017
- T. Rowe Price’s Asset Allocation Committee has moved to a neutral position between U.S. and international equities.
- The committee also has sought to moderate equity risk in its portfolios by adopting an underweight in emerging market equities.
- While the emerging markets earnings recovery appears intact, currency, interest rate, and trade policy risks all have risen.
- Persistent oversupply in oil and other commodity markets reinforces our preference for broad global equities over real assets.
- Yields on non-U.S. dollar bonds appear less attractive relative to U.S. dollar investment-grade bonds.
- Prospects for somewhat faster global growth should be supportive for high yield, although the credit cycle is well advanced.
Prospects for shifting economic and financial conditions in the wake of the U.S. presidential election—including expectations for modestly higher inflation and interest rates and a possible redirection of U.S. trade policy—led the T. Rowe Price Asset Allocation Committee to make several tactical changes to its diversified multi-asset portfolios as 2016 drew to a close. These moves were designed to position our clients for a 2017 market environment that may be more volatile than previously anticipated.
Broadly, the committee’s recent moves primarily reflect a focus on managing exposure to economic risks that potentially could work against international and/or non-U.S. dollar assets in 2017. These risks include the possibility that a more expansionary U.S. fiscal policy could push inflation higher and accelerate the Federal Reserve’s policy tightening pace, leading to additional U.S. dollar appreciation and potential capital outflows from emerging market (EM) countries.
At the same time, however, we believe expectations for somewhat faster U.S. and global economic growth should be supportive for credit-sensitive fixed income sectors such as high yield bonds. The reflationary implications of looser U.S. fiscal policy also should increase the relative attractiveness of assets that may offer some built-in protection against higher interest rates or inflation—such as floating rate bank loans and Treasury inflation protected securities.
In this context, recent changes to the committee’s portfolio positioning include:
- Moving to neutral on international versus U.S. equities. Earlier in the year, our overweight to international stocks was based on the fact that the U.S. is further along in the economic cycle, potentially leaving greater room for earnings acceleration in international markets. Continued quantitative easing by the European Central Bank (ECB) and the Bank of Japan (BoJ) also should be supportive of international equities. However, diminished growth expectations for many international developed economies, and the potential risks to global trade from the new U.S. administration, leave potential risks and opportunities equally balanced between U.S. and non-U.S. equities, in the committee’s view.
- Reducing allocations to EM equities versus developed equities. Earnings are beginning to recover in many of the EM economies hardest hit by energy and commodity price deflation, and valuations in many emerging equity markets are attractive relative to developed markets; however, these recoveries remain vulnerable to capital outflows triggered by currency and/or interest rate instability and to a potential protectionist turn in U.S. trade policy.
- Reducing allocations to non-U.S. dollar bonds versus U.S. dollar bonds. The rise in global bond yields since the U.S. election has widened the yield differential favoring U.S. investment-grade bonds relative to non-U.S. dollar-denominated debt. Quantitative easing by the ECB and the BoJ continues to suppress yields in the eurozone and Japan, offering unattractive risk/return trade-offs. However, we remain overweight to EM debt versus U.S. investment grade, reflecting the substantially higher yields available in the EM fixed income space, although EM local currency bonds may face additional pressure from a stronger U.S. dollar.
- Increasing allocations to high yield bonds versus U.S. investment grade. Faster U.S. growth and continued, if slow, earning recoveries in Europe and Japan should be supportive for high yield bonds. Floating rate bank loans, meanwhile, offer attractive duration characteristics in the event of an acceleration in U.S. inflation. However, our optimism is tempered by the maturity of the credit cycle.
CURRENT ASSET ALLOCATION PERSPECTIVES
The committee’s tactical portfolio positions are relative to our long-term strategic neutral allocations across our asset allocation portfolios and reflect our expectations for asset class and sector performance over the ensuing six to 18 months.
The committee typically focuses on overweighting segments of the market we believe are undervalued while lowering allocations to more richly valued asset classes or sectors. Our process incorporates a range of factors, including macroeconomic trends, market developments, and earnings expectations.
Changes within our portfolios tend to be gradual, building into meaningful positions over time based on our ongoing assessment of opportunities. Figure 1 provides an overview of our current positioning in the major asset classes and sectors.
As of December 1, 2016
Source: T. Rowe Price Asset Allocation Committee.
NEUTRAL BETWEEN STOCKS AND BONDS
Expectations for pro-growth U.S. economic policies have pushed equity prices to near-record levels since the U.S. presidential election. U.S. corporate earnings surprised to the upside in third-quarter 2016, breaking a string of five consecutive quarters of year-over-year declines for the S&P 500 companies. Although U.S. valuations are above historical averages and profit margins may come under late-cycle pressure, low but stable economic growth should remain supportive of most sectors. While our global growth expectations for the next several quarters remain modest, quantitative easing by the ECB and the BoJ should continue to be supportive for international equities.
Balanced against this cautiously optimistic equity outlook, we expect only modest returns from fixed income assets in a persistent low-yield environment. Rising U.S. interest rates are a potential headwind, although we still expect the pace of Fed tightening to be gradual. Moreover, most global central banks are expected to remain broadly accommodative in 2017, which should moderate downside risks.
Relatively subdued expectations for both global equities and global fixed income leave risks and opportunities evenly balanced between the two asset classes, in the committee’s view.
FAVOR GLOBAL EQUITY OVER REAL ASSETS
The committee remains underweight to equities linked to real assets, such as natural resources and real estate, in part reflecting our continued pessimistic outlook for energy prices given persistent global supply and demand imbalances (Figure 2). We are skeptical of the ability of the Organization of Petroleum Exporting Countries to meaningfully reduce supply, despite the production cuts announced at the end of November. We believe any cuts in supply are likely to be replaced by U.S. shale producers, who have been able to reduce their operating costs significantly. Meanwhile, demand for industrial metals should remain subdued as China seeks to rebalance its economy away from industrial production and exports.
The outlook for global real estate is more positive, as real estate equity valuations appear less extended versus broader equities. While real estate investment trust shares remain sensitive to rising interest rates, the expected gradual pace of Fed tightening should limit potential risk.
Global Demand Minus Supply vs. Brent Oil Price, Through September 2016
Sources: FactSet, OECD, and Energy Information Agency; analysis by T. Rowe Price.
FAVOR U.S. GROWTH OVER U.S. VALUE
We remain overweight to U.S. growth stocks relative to U.S. value stocks as relative valuations favor the growth universe, as do our expectations that U.S. economic growth will remain relatively subdued given the structural barriers (low population growth, slow productivity gains) to any pro-growth policy efforts.
To us, the post-U.S. election rally among lower-quality value sectors, including industrials and materials appears to be pricing in extremely optimistic outcomes from the policies expected to be pursued by the new Trump administration. While increased spending, tax cuts, and deregulation could provide support for sectors such as financials and energy, prospects for congressional approval for some of these measures remain uncertain, in our view.
FAVOR VALUE OVER GROWTH OUTSIDE THE U.S.
In international equity markets, we are modestly overweight to value stocks relative to growth stocks. Some key growth sectors—such as consumer staples—have become increasingly expensive, in our judgment. By contrast, many international value sectors remain attractively valued, although some sectors that are heavily weighted in the international value universe, including financials and energy, continue to face headwinds.
FAVOR U.S. INVESTMENT GRADE OVER NON-U.S. DOLLAR FIXED INCOME
As noted above, the Asset Allocation Committee reduced exposure to nondollar bonds relative to U.S. investment-grade bonds in late 2016. This reflected our belief that U.S. interest rates and the U.S. dollar are both likely to continue moving higher in early 2017 amid widespread speculation about a shift to reflationary policies, such as higher federal spending and tax cuts, and the potential for a U.S. turn toward protectionist trade policies.
Despite the postelection rise in global bond yields, ECB and BoJ quantitative easing measures continue to produce negative yields on short- and intermediate-term maturities in the core eurozone and in Japan. The effectiveness of monetary policy in these countries also appears limited, creating further downside risk. For example, recent attempts by the BoJ to target yield levels have resulted in yields moving higher. Going forward, the BoJ’s ability to keep the yield on the 10-year Japanese government note at the bank’s 0% target will be a critical test of monetary effectiveness.
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The views contained herein are as of January 2017 and may have changed since that time.
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