Synopsis

The two key global market trends of early 2018—U.S. growth leadership and the U.S. dollar bounce—have probably run their course. Be alert for an escalation in the trade-war issue, and keep an eye on the yield curve for a U.S. recession warning, although a recession seems unlikely before late 2019.

Key market themes

We maintain an underweight preference for U.S. equities in global portfolios, primarily on the back of their expensive valuations. The cyclically adjusted price-to-earnings ratio for the S&P 500® Index—commonly called the Shiller P/E ratio—stands at 32x in June 2018, which is its highest level outside of 1929 and the late 1990s. Our valuation conditional framework as of mid-year suggests the expected total return on U.S. equities over the next decade is likely to be very subdued—at only about 2% per year. Our underweight preference for U.S. government bonds and interest rate risk from prior years has shifted to neutral, as a 3% U.S. 10-year Treasury yield better reflects our macro outlook and the risks surrounding U.S. Federal Reserve (the Fed) policy and inflation.

We believe Asia-Pacific valuations are fair priced to slightly attractive across the region. We continue to like Japanese valuations and believe that part of the rise in Japanese profit margins is structural (rather than cyclical). Australia is close to fair value in our view. Developing Asia looks attractive, with the caveat that China H-shares are expensive due to the Chinese tech names. We expect to see solid performance out of the economic data and equity markets in the region, underpinned by strong Chinese activity, robust global growth, and supportive policy. However, an escalation in trade tensions or further strengthening in the U.S. dollar remain key risks.

We are neutral on eurozone equity valuations, while we see core government bonds as long-term expensive. We decided to slightly alter our range for eurozone core bond yields from 0%-0.8% to 0.2%-1.0% to line up with the low point in yields during the Italian political flare-up. We went underweight Italian bonds in April and moved to overweight subsequently in two steps when valuations jumped from expensive to cheap. We continue to favor euro zone financial markets over U.S. markets in particular. The push from strong fundamentals, relatively attractive valuation and supportive monetary policy will likely combine to outweigh the pull from increased political risk.