Despite a difficult start to the year for the US economy, strong global growth is still expected in 2015, led by developed markets. Continuing low interest rates and inflation, accommodative monetary policy, better credit conditions and improving business and consumer confidence, alongside the boost provided by lower oil prices, is a backdrop that should encourage faster and sustainable developed market growth.
While the current economic cycle may feel long in the tooth, the whole mid-cycle phase produced growth that was well below trend, such that no major economy has delivered even one year of strong growth since the first year of recovery. Given these conditions it would be a surprise if the economic cycle came to a halt now and it should have several years to run. This is a view shared by most central banks, which are pulling out all the stops to foster stronger growth.
Inflation is not a major issue as yet and debt levels, while worrying, are more an impediment to growth rather than a likely cause of another financial crash. One area of concern is high valuations both in bond markets, despite the recent yield back up, and in US equities, which provide little margin for error. Of course, there are also near-term issues, including a possible “Grexit” and a rise in the Fed funds rate, both of which are creating some anxiety and volatility.
Even so, equities remain preferred to bonds. Equity risk premiums are high relative to history and dividend yields are generally higher than those of government bonds. Long-term returns from bonds will inevitably be low. More generally, fixed income markets remain a concern and a conundrum as government bonds are expensive relative to fundamentals, yet the world is awash with investors seeking safe yield.
With full-year returns expected to be minimal at best, government bonds deserve only a relatively small position in a portfolio. Equity returns should comfortably exceed those from bonds, but the US is a relatively expensive market with little prospect of revaluation unless there is big rotation out of bonds into equities. Like bonds, however, equity fundamentals could be compromised and severe overvaluation normally only ends with one result.
