Midway through 2018, many of the world’s largest economies are enjoying a remarkable period of synchronized growth. By one estimate, global GDP growth will approach 4% this year. But the specter of tighter monetary policy, trade skirmishes, rising volatility and high valuations may leave investors wondering, “What’s coming next?”

Capital Group’s investment team has identified the following insights and corresponding actions to help investors navigate through these challenging times toward long-term investment success.

For nearly a decade, the world’s largest central banks have given new meaning to the term “accommodative.” In the wake of the Global Financial Crisis, central bankers slashed interest rates to pump liquidity into a global economy on the brink of depression. The U.S. Federal Reserve was the first to take rates to zero, and when that was insufficient to spur growth, the Fed started making massive asset purchases to provide more economic stimulus. 

Expect more volatility as the U.S. Federal Reserve unwinds its massive balance sheet.

The chart above suggests that central banks have reached a key inflection point. The Fed began raising rates in 2015 and reducing its balance sheet in 2017. The European Central Bank and Bank of Japan are reining in asset purchases. The assets of those three central banks total about $15 trillion. That massive amount of stimulus provided a significant tailwind to asset prices. Now, as policy tightens, the global economy is entering uncharted territory. How much of a headwind will markets face amid less supportive policy? That question is likely to influence markets for years to come. Investors should expect more volatility as a result.

CE credit webinar: 2019 Outlook

Join Capital Group investment professionals as they share insights on global markets and economies.
CE credit available for CFP and CIMA. 

 

Synchronized global growth should continue into 2019

On the economic front, the story remains quite positive. From the U.S. to the eurozone, the global economy is experiencing a synchronized and multidimensional pickup in growth. With manufacturing, consumer sentiment and other indicators mostly on the upswing, expansion is gaining traction in many of the countries driving global growth. Although some countries, such as Japan, are showing signs of slowing, the wider global growth trend is firmly in place.

Many of the world’s economies are contributing to the highest global growth since 2011.

Overall, the International Monetary Fund expects global GDP growth to hit 3.9% in 2018 — the fastest rate since 2011. Moreover, the IMF says the global recovery is the broadest in seven years, with growth picking up in countries accounting for three-quarters of world output. That growth is supported by accommodative financial conditions globally and expansionary fiscal policy in the United States. With few imbalances, the global economy remains broadly healthy and on pace to advance.

The QE tide lifted most boats, raising asset prices

If you feel like everything is expensive, you’re not alone. From real estate to fine art, prices appear elevated. So it is with the markets. U.S. stocks were at their most expensive in 15 years recently before the P/E ratio retreated as earnings got a boost from U.S. corporate tax cuts. Bond valuations have also been stretched, leaving credit spreads near their tightest levels in years.

At these levels, investors need to manage expectations for future returns.

The strengthening economy is one reason the U.S. stock market has soared since the end of the Global Financial Crisis. In such an environment, some companies and sectors of the market appear to be relatively expensive. Bottom-up fundamental research can help identify future investment opportunities, as well as test current investment theses. In a market where everything is expensive, selectivity will increasingly be important since not all boats will continue to rise — and some may sink under the weight of lofty valuations.

Actions to consider: 

  • Evaluate portfolios to ensure broad diversification this late in the cycle. 
  • Check correlations between equity and fixed income portfolios. Lower correlations (closer to 0) provide greater diversification.

Global trade issues are once again headline news amid growing U.S.-China trade tensions, talk of renegotiating the North American Free Trade Agreement and the United Kingdom’s attempt to break away from the European Union. That’s a lot of potential change on the horizon, and the outcome remains uncertain. However, over the past two decades, much bigger shifts have completely reshaped the global trade environment in powerful and likely irreversible ways, changing the investment landscape along the way.

Rapid changes in global trade present opportunities as the old economy gives way to the digital age.

If the 20th century was defined by a phenomenal rise in the transfer of goods and industrial commodities, the 21st century is being characterized by the rapid digitization of services. Innovative technology platforms are facilitating this digital trade. Moreover, the movement is not easily captured in traditional trade metrics or controlled by government regulations. Thus, the flow of data and capital over digital networks can’t be easily thwarted.

Companies that are thriving in the era of digital trade include Alphabet (Google), which, along with Facebook, dominates the online advertising space; Amazon, which is radically disrupting both retail shopping and cloud-based hosting services; and Priceline, the largest online travel agency in the world. In their own market, several Chinese internet companies are just as dominant, including Alibaba and Tencent, marking a clear line between winners and losers in the digital age.

Attractive valuations abound abroad

International equities remain attractive, given steady global economic growth, central bank stimulus measures and lower valuations compared to U.S. equities. In addition, political stability is returning to the European Union in the wake of last year’s elections. Investor sentiment may continue to improve as French President Emmanuel Macron and German Chancellor Angela Merkel solidify a power base that should dominate the EU after the United Kingdom’s planned exit in March 2019. Recent political turmoil in Italy and Spain hasn’t helped but, at the moment at least, the trouble appears containable.

Many non-U.S. companies trade at significant discounts to their U.S. counterparts.

Among several interesting areas of opportunity, the European financials sector offers a number of potentially attractive valuation stories. Many eurozone banks have struggled in recent years with sluggish economies, strict regulations and a low-interest-rate environment. But renewed economic growth and the prospect of higher interest rates next year mean select banks look relatively attractive, including Barclays, Credit Suisse and UniCredit.

Emerging consumers are leapfrogging the developed world

In emerging markets, the rapid adoption of mobile devices — including smartphones, tablets and other internet-connected gadgets — is driving powerful consumption trends. Fast-growing markets such as China, India and Brazil are at the epicenter. To underscore that point, consumers in many developing countries are surpassing their developed-market counterparts when it comes to the growth of ecommerce and the use of other online services.

Select companies are gaining from rising smartphone adoption and mobile commerce.

In certain areas, such as mobile payment platforms, Chinese tech companies are building massive scale and leapfrogging Silicon Valley in advancements. Indeed, emerging markets investing isn’t just about commodities anymore. Technology companies based in emerging markets are now among the largest companies by market capitalization in the developing world. Examples of EM companies capitalizing on mobile device trends include South Korea’s Samsung Electronics, India’s Reliance Industries and China’s Ctrip, among other

Actions to consider: 

  • Rightsize your international equity allocations. Many of our model portfolios are above 24% non-U.S.
  • Combine a dedicated international holding with a flexible global strategy for a broader opportunity set.

In the bond markets, naturally, all eyes are on U.S. interest rates. The 10-year Treasury note yield topping 3% in April and May has only increased that focus. Short-term bond funds have tended to be less sensitive to changes in rates, and have become a popular choice for de-risking. But there’s a snag: Some funds may not behave as expected. That’s because credit risk is lurking. For example, in short-term bond strategies — which should emphasize capital preservation and diversification from equities — credit fund-like behavior is surprisingly common.*

Bond funds should provide diversification from equities. Knowing what you own is critical.

Later in the cycle, credit risk in bonds should also be front-and-center. Although Corporate America is prospering, debt levels are rising. Moody’s estimates that nonfinancial corporate leverage has reached a record high of just over 45% of U.S. GDP. And with short-term rates now higher than they’ve been for years, there’s no need to stretch for yield. Shorter term funds that emphasize high-quality bonds can now offer solid income potential without taking excessive credit risk.

Some bond strategies may be vulnerable amid stock market declines. Investors should ensure their bond investments are appropriately aligned with the four primary roles of fixed income in a balanced portfolio: diversification from equities, capital preservation, income, and inflation protection.

The income comeback is here

Welcome back, income. In late 2017, the two-year U.S. Treasury yield rose above the S&P 500 Composite Index dividend yield for the first time in almost a decade. So far in 2018, shorter term bond yields have continued to trend higher. For income investors, this is a sea change. Years of ultra-low bond yields had led investors to turn to equities for income. Now, rising interest rates are shaking things up. Relatively attractive opportunities in higher quality bonds can supplement income from equities, where dividend yields have been fairly flat overall.

Shorter term bonds lead the way for the first time in nearly a decade.

Higher bond yields make this a great time for investors to reconsider bonds for income. Balanced funds are worth a closer look, as are shorter term core bond strategies. They’re focused on higher quality bonds of shorter maturity and can offer an attractive complement to equities

Rethink high yield without giving up income

U.S. corporate high-yield bonds have benefited from strong demand and modest net issuance. Default rates have moderated and many issuers that are sensitive to commodities have strengthened balance sheets. All that said, debt burdens remain heavy and an extended rally has left valuations elevated. In comparison, high-income municipal bonds and emerging markets bonds have offered comparable yields — even among higher quality issuers.

High-income munis and emerging markets debt can complement high-yield corporate exposure.

Fundamentals for many emerging markets appear more favorable than in developed nations, with higher commodity prices providing a boost to exporters. Valuations have eased lately and volatility around Turkey and Argentina — as well as a bout of U.S. dollar strength — underscores the need to invest selectively. High-income munis have also seen volatility. With valuations elevated, bond-by-bond research is an especially critical aspect of uncovering favorable tax-advantaged opportunities.

Further increases in U.S. Treasury yields may cause setbacks for emerging markets debt and high-income munis. Developments such as Brazil’s October election, or negative news around certain troubled muni issuers are possible sources of volatility. Market wobbles could present attractive entry points for investors considering a reallocation of some high-yield corporate exposure.

Actions to consider:

  • Favor true core strategies, and be alert to unintended credit exposure.
  • Rethink high yield with emerging markets and municipal bonds.
  • With inflation rising, consider adding inflation protection.

Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility, as more fully described in the prospectus. These risks may be heightened in connection with investments in developing countries.