A Synchronous Global Economic Expansion - Janney Montgomery ...

GLOBAL ASSET ALLOCATION Pick up the Pieces

MARK LUSCHINI, CHIEF INVESTMENT STRATEGIST FALL 2017

A SYNCHRONOUS GLOBAL ECONOMIC EXPANSION The global economy remains in a reflationary window. Leading economic indicators are sturdy and rekindled animal spirits are igniting a capex upcycle. Consumer confidence is elevated and, if past is prologue, this will extend the healthy pace of consumption. The synchronous pattern of global growth continues to be supportive for risk assets in general, but also lays the foundations for shifting monetary policies underwritten by the world’s systemically important central banks. Non-inflationary growth is unlikely to inflame a rapid movement in interest rates so the “sweet spot” for equities should remain intact. Tactical Weighting - Excluding Alternative Investments. 100% Stocks*

80% Stocks 20% Bonds




100% Bonds*

U.S. Stocks

51

41

31

20

10

0

International Stocks

36

29

22

15

7

0

Emerging Market Stocks

7

6

4

3

1

0

Fixed Income

0

20

40

60

80

100

Other/Alternatives

3

2

2

1

1

0

Cash

3

1

1

1

0

Category

2

*The benchmark weightings for Stocks is the MSCI ACWI index. Fixed income recommendations will generally be based off the Bloomberg Barclays Aggregate Bond Index.

Overall Strategy: We believe Investors should overweight equities while underweighting safe-haven bonds and cash. While a correction is long overdue, as long as the global economy continues to operate at a relatively robust pace, the cyclical outlook for risk assets will remain bullish. A more cautious stance would be warranted when the risk of a recession becomes apparent. Equities: Global earnings per share are expected to expand by double digits this year, supporting the advance in global equity markets. Favor higher-beta developed markets such as Europe and Japan relative to the U.S. in local currency terms. Emerging markets will benefit too, but near- to intermediate-term structural issues and a re-strengthening U.S. Dollar, will dampen returns. Fixed Income: Central banks around the world are gradually moving toward less accommodative monetary policies as the financial crisis-induced emergency measures are no longer necessary. Underweight U.S. Treasury and Euro area bonds. For the same reason we hold a below benchmark weight for emerging market equities, underweight emerging market debt.

MARK LUSCHINI, CHIEF INVESTMENT STRATEGIST [email protected] 412-562-7904 WWW.JANNEY.COM © JANNEY MONTGOMERY SCOTT LLC MEMBER: NYSE, FINRA, SIPC

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Other/Alternatives: After a prolonged bout of weakness in the U.S. Dollar this year, we believe the path of least resistance for the trade-weighted currency is higher. The Euro currency should grind lower as interest rate differentials widen against the U.S., but the Japanese Yen has considerable downside. The setting for gold may be shifting should the Dollar strengthen and geopolitical risks recede as we expect. A strategic holding in gold may be warranted, but we prefer oil in the commodity complex. Global Equities Equity bourses across the globe have rallied posting double-digit gains almost without exception. The stretch of low volatility and historically shallow dips is uncommon, but speaks to the synchronized behavior of markets responding to almost uniform monetary accommodation, non-threatening levels of inflation, and at or above trend growth. In fact, all of the 45 countries covered by the Organization for Economic Cooperation and Development (OECD) are growing—the first time that has occurred in a decade. Positive economic activity has provided a fertile backdrop for corporate profitability. Earnings have been quite strong, and should remain so for at least the next several quarters before moderating. In our judgment, the window for the equity advance to continue remains wide open. Domestic U.S. equities have rallied impressively due to steady, if not accelerating, economic growth, benign inflation, and no risk that interest rates will jump materially or unexpectedly. While valuations have risen to levels that challenge historical comparisons outside major market melt ups, based upon forward expectations and the low rate environment persisting, that alone is not enough to snuff out the bull. The fundamental underpinnings support a favorable disposition toward cyclical sectors of the market, in other words, those most sensitive to the economic cycle. As a consequence, we host a positive sentiment toward industries such as housing, energy, financial, and industrial companies. We have not abandoned our view that small caps should be favored, although the returns have not kept pace with their larger cap brethren so far this year. Our call hinges on the passage of corporate tax reform and delays and/or distractions on that legislative slate have occasionally soured sentiment toward that space. Our belief is some form of tax cuts will pass and prove to disproportionately favor small companies since many pay taxes at the highest corporate tax rate. International We continue to prefer Euro area and Japanese stocks relative to U.S. equities. We would only buy Japanese stocks on a currency-hedged basis, as the prospect of a weaker yen is the main, but not only reason for being overweight Japan. In contrast, we would still buy Euro area equities on a U.S. Dollar basis, even though our central forecast is for the Euro to weaken against the U.S. Dollar over the next year. Our bullish view on Euro area equities reflects several considerations: 1) While they have gained more than U.S. stocks this year, valuations are still undemanding, 2) Earnings growth in Europe is accelerating at a faster pace than comparable profit growth in the U.S., and 3) The European Central Bank is hosting a very loose monetary stance when compared to the Federal Reserve. Similarly, our view on Japanese equities is grounded in: 1) The economy has shown a pattern of growth unrivaled in over a decade, 2) Fiscal policies under the recently re-elected PM Abe are working, and 3) the Bank of Japan is keeping the 10-year bond yield pegged at 0%, which should weaken the Yen and boost Japan’s exports. Emerging market equities have performed very well, which they tend to do when global growth is strong and commodity prices are rising. However, the structural problems plaguing many emerging market countries, such as mal-investment, wide current account deficits, and excessive amounts of dollar-denominated debt, present concerns should global activity moderate. China recently concluded its 19th Party Congress, and renewed its commitment to address the environment and to its pivot toward a more consumption-led model. Each could also have blowback consequences to commodity-producing emerging economies.


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Fixed Income Domestic While we posit the 35-year bull market in bonds is over, the transition to a bear market is more likely u-shaped than v-shaped. Having said that, we think that asset allocators should maintain an underweight position in global bonds. In relative terms, we disfavor rate-sensitive sovereigns and instead prefer corporate bonds. High yield bond spreads have narrowed to near record lows, but the economy’s strength and a low default ratio provide high yield corporates a reasonably attractive carry against Treasuries. Municipal bonds provide decent value given yields on their taxable counterparts; however, changes to the individual tax rates that might affect the attraction of these instruments for high income earners is something to monitor. International Yields in the Euro area will follow the general contours of the U.S., but with several important qualifications. The European Central Bank has already announced the pending reduction in its volume of monthly bond purchases, and will eventually begin to raise interest rates. While the bank’s head, Mario Draghi, did a masterful job of telegraphing a “dovish” message accompanying the change in policy, with yields on European debt so low (just 0.4% in the case of a 10-year German bund) even a small move in rates can quickly produce a nasty result. Therefore, we argue for underweighting European bonds. A substantial portion of emerging market sovereign debt is dollar-denominated. Should the U.S. Dollar rise in value, as is our base case, it will increase the financing in many emerging market countries. A tremor caused by a financial misstep in a country that has a large funding requirement and fiscal weakness could ripple through the emerging market universe. We would underweight emerging market debt for now. Other/Alternatives Commodities We have favored gold among offerings within the commodity complex and it has delivered handsome gains year-to-date. In fact, compared to the broader commodity complex, gold has outperformed by more than 10%. A rescission in geopolitical uncertainty has cast some dust on gold’s shine. Bullion still offers strategic merit for those who value its efficacy as a long-term “hedge,” so holding an allocation to it can be prudent. Within the commodity complex, however, oil has held similar appeal. Somewhat controversially, we recommended energy stocks earlier this year on the expectation that oil prices would rise, which they subsequently have. The experiment undertaken by OPEC and Russia has successfully worked to draw global inventories down as demand continues to grow. That boosted oil prices and bolstered the shaky belief held by market participants that the cartel’s commitment to compliance was firm. We expect oil prices to trend higher and average better than $60/barrel over 2018. Currencies Interest rate differentials between the U.S. and its trading partners are likely to widen further as other central banks lag the Federal Reserve in shifting to a less accommodative policy structure. Among the major U.S. Dollar crosses, we see the most downside for the Japanese Yen as the Bank of Japan continues to keep Japanese Government Bond yields anchored at zero. We also expect the Euro currency to weaken against the Dollar, although probably not as much as the Yen. Europe is growing above trend and while inflation is below the ECB’s target, the gap is much narrower than that which exists in the Japanese economy. Other crosses of note include: 1) China remains a risk for the Aussie dollar and 2) the Canadian Loonie is well positioned given the boost in oil prices. MARK LUSCHINI, CHIEF INVESTMENT STRATEGIST [email protected] 412-562-7904 WWW.JANNEY.COM © JANNEY MONTGOMERY SCOTT LLC MEMBER: NYSE, FINRA, SIPC

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Risks to Our Outlook • Geopolitical Destabilization o North Korea – While a diplomatic outcome is our base case, an economically-impactful encounter, provoked or otherwise, would upend markets at least temporarily. o South China Sea – China’s expanding sphere of influence has pushed into waters where $4 trillion of cargo pass every year. This could be a flashpoint for regional rivals given how vital these supply lines are. • Trade o Mercantilism – The Trump administration keeps score by trade balances. Sanctions and tariffs could lead to a tit-for-tat retaliation with negative economic outcomes. o The Dollar – A stronger dollar could crimp corporate profits of U.S. multinationals who collectively generate half of their earnings from overseas markets. • A Monetary Policy Blunder o The Federal Reserve could 1) be slow to raise rates and get caught behind an unexpected rise in inflation, or 2) raise rates faster than warranted and retard growth, in either case spooking the markets. This report is provided for informational purposes only and shall in no event be construed as an offer to sell or a solicitation of an offer to buy any securities. The information described herein is taken from sources which we believe to be reliable, but the accuracy and completeness of such information is not guaranteed by us. The opinions expressed herein may be given only such weight as opinions warrant. This Firm, its officers, directors, employees, or members of their families may have positions in the securities mentioned and may make purchases or sales of such as securities from time to time in the open market or otherwise and may sell to or buy from customers such securities on a principal basis. There are no guarantees that any investment or investment strategy will meet its objectives or that an investment can avoid losses. Investment products offered are not insured by the FDIC or any other government agency. They are not deposits or obligations of, or guaranteed by the financial institutions where offered. They also involve investment risk and past performance is not an indication of future results.


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