In a context of high economic visibility, more predictable central bank actions, decent earnings growth, no valuation excesses and a smidgen of higher asset-class volatility, our asset allocation favours equities over bonds. Within equities, our biggest investment convictions are our overweights in European small- and mid-cap stocks and in Japanese and emerging market equities. Within the fixed income universe, we think a short duration on developed market government bonds is warranted, as is being neutral on credit and overweight on emerging markets.
Is this the end of Goldilocks? We expect the Goldilocks scenario of positive growth and little inflation pressure to prevail in 2018. Although it is likely to register somewhat less cyclical growth and more cyclical inflation, the investment environment throughout 2018 should remain favourable. Candriam’s asset allocation is positioned for above-trend expansion, due to the positive feedback loop instigated by accommodative financial conditions and supportive business and consumer sentiment. It took an unusual amount of time to see the major economies (G7) close their post-2008 output gap. If history is any guide, several quarters of positive output gap should start now.
Could asset class volatility finally rise in 2018? Supported by above-trend growth and little inflationary pressure in many parts of the world, valuations have risen and volatility on equities, bonds and currencies has fallen. Broadly speaking, it is possible to characterize four different volatility regimes, two in an overall contracting economy and two in an expanding environment. Since early-2016, we have been in the most favourable regime for low asset-class volatility, as economic expansion has been accelerating and its diffusion spreading across many sectors. Historically, asset volatility is at its lowest level in the phase of growth acceleration and increases when the economy slows down. In the coming quarters, we expect a continuation of positive (but slightly less) growth momentum and little (but slightly more) inflation pressure. As momentum slows but the expansion continues, this would be a first step towards a slightly higher volatility regime.
Candriam’s current asset allocation favours equities over bonds. From a regional point of view, we favour EMU, Japanese and emerging market equities, while avoiding the UK. Within Europe, we continue to favour domestic exposure and – as a leverage on economic growth momentum – small- and mid-caps that are less sensitive to the exchange rate.