The U.S. macroeconomic backdrop will, in sum, remain a significant headwind for bond performance and will be reinforced by the eventual prospect of European monetary policy also being normalised from its previous ultrastimulatory stance. In the circumstances, it is not surprising that fund managers are wary of the asset class. The latest (April) Bank of America Merrill Lynch survey of global managers found that they were overwhelmingly underweight to bonds (a net 62% underweighting, which is the number you would get when 81% are underweight and only 19% are overweight).

Some of the higher-yield sectors that investors have been using to boost returns from the sector may also have run their course, as demand has pushed yields and credit spreads to unsustainably compressed levels. As a recent Weekly Letter from Merrill Lynch noted, for example, in the corporate high-yield market “Spreads are well below average levels for the sector as a whole and for every credit category within it, with prospective returns for the buy-and-hold investor hovering in the mid- to low 3% range. Yields are quite low by historical standards and are barely covering average credit losses for bonds rated CCC and below.”

International Equities — Outlook

The most recent survey data suggest that while the pace of growth in the U.S. may have come off the boil, improved prospects elsewhere have helped the global economy to keep growing.

In the U.S., for example, the latest (April) IHS Markit Purchasing Managers’ Index (PMI) showed that the American economy “lost further momentum at the start of the second quarter,” although there were indications that it could pick up later in the year: “With inflows of new business picking up slightly in April and business optimism about the year ahead also brightening, there’s good reason to believe that growth could revive again in coming months.” Whatever temporary slowdown is occurring in the U.S. has been counterbalanced, by upturns elsewhere, particularly in the strengthening eurozone economy. The latest (April) IHS Markit PMI data for the eurozone found that “Eurozone economic growth hit a fresh six-year high in April. Job creation also rose to the highest for almost a decade as firms boosted operating capacity in line with buoyant demand and widespread optimism about future prospects.”

The International Monetary Fund (IMF) in the latest (April) update of its flagship World Economic Outlook report was also positive: “Global economic activity is picking up with a long-awaited cyclical recovery in investment, manufacturing, and trade. World growth is expected to rise from 3.1 percent in 2016 to 3.5 percent in 2017 and 3.6 percent in 2018.” This outlook for ongoing global growth is shared by institutional fund managers. In the latest (April) monthly Bank of America Merrill Lynch (BAML) survey of global fund managers, they said they were optimistic about global corporate profits (a net 50% expect profits to grow during the coming year). They do not believe there is great value on offer–a net 32% think global equities are overvalued–but the outlook for the global economy means they are still prepared to favour equities (a net 40% are overweight).

But they also had pronounced views about which equity markets they preferred: Some markets are seen as offering much less value than others. The overall overvalued status of world equities stems almost entirely from the U.S., where an all-time record (net 83%) think the U.S. market is overvalued, and the percentage underweighting (net 20%) is the highest since January 2008 in the early days of the GFC. Fund managers also thought the U.S. dollar was overvalued, making it a double whammy for U.S. equity allocations. The main counterpart to underweight U.S. allocations is principally overweight eurozone exposure (a net 48% overweighting) assisted by a positive view on the euro, which a net 30% believe is undervalued. Emerging markets are another favourite: Fund managers are a net 44% overweighting, with a net 47% of the view that emerging-markets equities are undervalued.

The IMF mentioned that the generally positive outlook nonetheless carried risks that are “tilted to the downside,” though the IMF thought they are more likely to cause trouble somewhere down the medium-term track than imminently in the next few months. It listed six in particular: protectionism, uncertainty around the U.S. policy agenda, financial sector fragilities, potential setbacks to emerging markets, ongoing problems in the weaker eurozone countries, and noneconomic factors, where it said that “Geopolitical tensions as well as domestic strife and idiosyncratic political problems have been on the rise in recent years, burdening the outlook for various regions.” The fund managers in the BAML survey broadly agree with the IMF’s list. They see the main risks as European Union disintegration (chosen by 23% as their main concern), delayed U.S. tax reform (21%), and trade wars (17%).

Unfortunately, global equity markets appear to be putting a low probability on any of these risks materialising in a meaningful way. Investors continue to pay high valuations by historical standards for equities, especially in the U.S., and the VIX measure of expected U.S. share market volatility remains at unusually low levels, despite (for example) the unexpected U.S. air strikes on Syria, which worsened U.S.-Russia relations, or the current heightened tension over North Korea. The gold price, a traditional indicator of investor fear, has admittedly risen this year (by 11.4%) but is now only back to where it was a year ago, and it remains well down on its high-crisis levels seen at the end of the GFC.

The outlook, in sum, is unchanged: There is a reasonable economic outlook supportive of equity performance, but equities remain susceptible to reassessments of the value on offer and to risks materialising that investors do not currently seem to be prepared for.

Performance periods unless otherwise stated generally refer to periods ended April 21, 2017

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