Chief Investment Strategist
March 16, 2018
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We believe valuation pressures and growth fears will be resolved with further moderate gains in global equities over the year to come
The Citi Private Bank Global Investment Committee on 14 March left in place its asset allocation of +4% to Global Equities. Global Fixed Income remains underweight by 4%. Within fixed income holdings, we raised our overweight to US investment grade debt (munis for US taxpayers) 0.5% by reducing our overweight to US high yield an equal amount.
The move comes as US interest rates have risen sharply relative to other global yield opportunities. The small step aims to gradually reduce portfolio volatility looking forward. In February, both global stock and bond markets declined together on concerns over higher US interest rates. Subsequently, additional growth fears were stoked by trade protectionist measures.
Such steps could potentially threaten growth while stoking inflation. Following the drop, we would not expect high quality fixed income and equity markets to maintain such a strong positive correlation looking forward.
Inflation is well below typical thresholds for severe, sustained declines in both major asset classes at the same time. With the rise in US interest rates driving a revaluation of all global bond market segments, US investment grade yields have risen to cycle highs compared to sub-investment grade debt.
Meanwhile, investment grade has a historically lower level of absolute volatility and correlation to equity markets. For US tax payers, municipal debt shows an even lower correlation, and now averages a 4.25% taxable-equivalent yield across all maturities.
We expect decent positive returns in US high yield debt when viewed as a single asset class. We remain overweight US high yield within global allocations. However, we prefer to now gradually shift bond holdings to their defensive function within multi-asset-class portfolios.
Global equities have predictably been more volatile after 2017’s record low volatility level. Equities lead corporate earnings trends, and valuations rose during the past two years in anticipation of EPS gains. However, we expect very strong earnings results to support returns as valuations compress.
In the US, the first quarter US corporate earnings reporting season is likely to show large cap EPS rose 20% from a year ago. Global earnings gains still remain somewhat under-estimated for 2018 in our view. Interest rate pressures remain a key concern for all markets as US funding needs rise on tax cuts, higher government spending, and a reduction in Federal Reserve bond holdings.
However, the Fed’s tightening steps have helped contain inflation expectations, and foreign central banks have added to US Treasury holdings in each of the last six weeks. Risks to global trade remain elevated as the US intends to confront China’s trade practices in coming weeks or months.
However, only a severe breakdown in trading relations would threaten the global economic expansion in our view. On the fears we have noted above, global equity markets have stalled while corporate earnings continue to grow strongly. We believe valuation pressures and growth fears will be resolved with further moderate gains in global equities over the year to come.