While the immediate outlook remains supportive of growth assets, in the longer term we see need for caution.
Our investment-cycle clock (above) shows the long-term economic cycle in the US. What can be clearly seen is that the economy is now on an upswing, as it has been for several years. At its current pace it will reach the 0.5 reading in the graph within 18 months, which is the level in the previous three cycles forewarning of an approaching peak in equity markets.
While the clock now approaches levels generally consistent with markets being expensive and the economic cycle sitting in the “boom” phase, it is too early for investors to go to a defensive portfolio allocation. In short, the current signal is likely telling us to expect positive returns to shares in 2018 with downside risk rising later in the year and into 2019. Such a downturn is consistent with our ‘good times fade’ scenario.
What else could happen in 2018
But what would challenge this scenario is a more pronounced lift in US wages and inflation than we currently assume. By around the end of 2018 our indicator suggests that wages could accelerate from 2.5 per cent to around 3.5 per cent and reach more than 4 per cent by mid-2019.
The risk is that US labour-market conditions continue to tighten unabated given above-trend growth. Signs in Europe point to a similar risk there. Under this ‘inflation scare’ scenario, as well as wage growth, US inflation would accelerate (above 2.5 per cent by year end). This would lead to more rate rises than expected by the US central bank. If we add the possibility of Europe cutting its economic-stimulus program then both shares and bonds are likely to take a hit. We think there’s about a 30 per cent chance that this will eventuate in 2018.
Much less likely is a gradual slide in growth driven by a steeper decline in the Chinese economy than currently predicted. Even though inflation and interest rates remained low, such a scenario would support a more defensive position by investors in 2018 with the environment favourable for bonds but not for the Australian dollar and shares.
Our view is that central banks have time and can lift their rates gradually and this will support trend returns for growth assets in 2018 while bonds will deliver flat returns.
The leading risk to this is faster-rising inflation, which would mean that our investment-cycle clock would tick more rapidly. This would bring forward strategies to mitigate the risk associated with more rapid central-bank tightening, rates increasing and weaker share and bond markets.
In light of all this, our tactical asset allocation strategy balances the risk of the various scenarios that may unfold. From a portfolio perspective we balance these risks by holding a small “overweight” to shares, with a bias away from interest-sensitive sectors such as real-estate investment trusts and infrastructure. We hold an “underweight” to fixed income, focused in international bonds, where we see more risks of upward surprises on inflation and continue to hold our "neutral" position to the Australian dollar.