The Global Purchasing Managers' Index - a good leading indicator of the global economy, has had a gradual uptrend over the last four years. The United States economy has led, but now there is an important upward movement to rest of the world that was lacking before.
The conditions that have enabled the U.S. to sustain growth appear to be finally falling into place in Europe. There are continued challenges, but European banks are more willing to lend and consumers are more willing to borrow: Consumer confidence in Germany is at its highest level in the past 10 years.
There is very strong consensus that the U.S. will raise short term interest rates. Does that mean they will destabilize the economy and capital markets with a high level of interest rates? Not likely, as inflation is low: the urgency to raise rates isn't there. We expect very gradual rises in short term interest rates.
In fixed income, we are moving towards a more ordinary monetary policy, so yields on 10-year U.S. Treasury Bonds are expected to gradually rise. With yields so low, it doesn't take much of an increase in interest rates to wipe out your coupon income. So, we are expecting low single-digit returns or even negative real returns on sovereign bonds.
Equity return expectations have to be moderated as U.S. equities have moved from being well below fair value in 2009 to much closer to fair value now.
For a long time, we've been overweight equities and underweight fixed income, particularly sovereign bonds. If we've moved out of a super-cycle bear market, where you had 10 years of correction and consolidation from 1999 to 2009, you should expect strong, long-lasting bull markets and fairly brief bear markets. So, if we do experience some sort of correction, 15-20% would be the maximum we would see in a period like this, and you would get to reload for the next bull market. You would want to reflect some chance of correction in your asset mix, but we are still above neutral exposure with regard to equities.
Within equities, we've been heavily overweight in the U.S. for some time. We're harvesting some of that, increasing exposure to Europe. Opportunities are still reasonable in the U.S., but you might see some lower returns in the United States and higher volatility because valuations are higher. But they are improving in Europe and I think they are still quite attractive in emerging markets.
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