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SPRING 2015

For capital markets, 2015 has so far featured considerable uncertainty. Energy prices have convulsed, the Fed is planning its first rate hike in many years as other central banks are again easing policy, the European Commission is facing more challenges from Greece, Russian aggression and ISIS atrocities are dominating the news and, as before, global growth and inflation remain sluggish. We have lowered our economic forecasts slightly for 2015. Nevertheless, it is important not to overstate the extent of these challenges on our forecast revisions as the global economy still looks set to produce better economic growth than last year.

Lowering growth forecasts, but still cautiously optimistic

Despite our forecast revisions, we continue to believe that both global and developed-world economic growth will improve in 2015, and again in 2016. Our forecasts are all on or above consensus with the exception of Canada (due to oil), China (due to credit) and Russia (due to oil and sanctions). Much of our cautious optimism stems from the anticipated potency of sharply lower oil prices, a new round of monetary stimulus that has pushed bond yields even lower, and more competitive exchange rates. We also believe that the global business cycle should be capable of extending its gains given the historical precedent that deep recessions and financial crises are usually followed by a longer-than-normal period of expansion.

Oil prices continue to languish

The sharp decline in energy prices remains a key global theme. In our view, oil prices have overshot fair value and so should rise significantly over the next several quarters. A price of around $80 per barrel should balance medium-term supply and demand. While oil-producing corporations and oil-exporting countries have been punished in the markets, beneficiaries of low oil prices form a far larger list than that of countries that suffer. Among those that come out ahead are such goliaths as the Eurozone, Japan, China and India and the U.S. (which produces a large amount of oil but consumes even more). In fact, G7 economies have historically managed substantially faster growth after periods of declining oil prices.

Inflation remains low

Global inflation continues to fall. Both the Eurozone and U.S. now have consumer prices that are lower than a year ago. While deflation can have negative consequences, a fair chunk of the current downward trend in consumer prices falls into the category of “good” deflation as it originates from supply-side and/or external shocks, as opposed to anemic demand. We suspect inflation rates will slip by more than the market is assuming in the near term, as the indirect effects of lower oil prices trickle through the system, and we have aggressively cut our inflation forecasts to reflect this. However, with oil prices likely rising substantially by the end of the year and given our longstanding opinion that there may be less economic slack in developed-world economies than commonly imagined, inflation should rebound by 2016.

Continued U.S. dollar strength

The dollar bull market is in full swing, with various factors playing a role in its strength at different times. Most recently, expectations of rate normalization by the Fed and consequences of the spectacular fall in oil prices have dominated investors’ attention. The fact that other key central banks are pushing on the monetary accelerator adds to the potential for this U.S. dollar bull market to unfold like others have, with currencies of the major U.S. trading partners falling into oversold territory.

Central banks tilt toward dovish stance

Although the next policy move for the Fed is very clearly to raise interest rates, other central banks have moved in the opposite direction. The European Central Bank (ECB) and Bank of Japan (BOJ) in particular are delivering more than enough stimulus to offset the Fed and, as a result, there is no shortage of money in the world today, with the consequences continuing to be felt via ultra-low yields around the world.

Bond yields likely to rise, but will remain low

Global bond yields remain at very low levels. We continue to believe that bond yields will begin to rise this year, with the most obvious catalyst being the beginning of a tightening cycle in the U.S. In addition, the ECB, BOJ and other central banks that are delivering major stimulus are unlikely to announce significant expansions to their programs over the year. We expect rate hikes to be gradual in the absence of inflationary pressures, but the impact of even modestly rising rates will still be significant given how low bond yields have fallen. As residual risk aversion from the financial crisis declines and unorthodox monetary policy is unwound, we expect that investors will eventually demand a higher after-inflation return on fixed-income securities. The resulting rise in real rates will pull nominal yields higher and deliver low or even negative total returns for bond holders across most investment horizons.

Equity returns will depend more on earnings

Following a volatile start to the year, global equities have risen to new highs, pushing most major indexes closer to fair value. While higher valuations do not necessarily place the bull market at risk, we expect more modest total returns and higher volatility going forward. As valuations become less supportive, the market will depend on profit growth for returns. We have experienced fairly substantial downgrades to earnings expectations in recent months due to the significant decline in oil and the stronger U.S. dollar. Although lower earnings growth is seldom positive for stocks, these downgrades have been narrowly focused on these two themes, and are not indicative of a broad-based deterioration in the outlook for the economy and/or corporate profitability. Given the significant decline in estimates thus far and our view that the oil price has likely bottomed, we believe that much of the bad news has likely been absorbed.

Global equity markets have risen considerably over the past few years, causing many to question the sustainability of the rally. While it appears that the cyclical bull market may in fact be maturing, the experience of the last decade where severe bear markets wiped out the gains enjoyed during the preceding bull phase may be a poor model going forward. A variety of indicators – including the depth of the last market and valuations at its conclusion – suggest that the way ahead may feature firm and durable bull phases interrupted by brief and comparatively mild corrections.

Relative return potential favours stocks

Our analysis of prospective total returns continues to favour equities over bonds across most time frames. In fact, while we have lowered our total-return expectations for stocks to reflect higher valuations and tamer earnings forecasts, sovereign bonds are expected to produce low or negative total returns through the relevant investment periods.

Reflecting all of this, we have maintained our overweight position in stocks and underweight in bonds. Within fixed income, we are generally maintaining above-benchmark exposure to higher-yielding corporate bonds as the additional coupon income should offset some of the pressure on returns in a rising rate environment. Within equities, we have shifted some of our exposure to Europe and emerging markets, harvesting gains made over the past few years in the U.S. For a balanced, global investor, we recommend an asset mix of 61% equities (strategic neutral position: 55%) and 38% fixed income (strategic neutral position: 40%), with the balance in cash.