We see the world economy in a synchronized and sustained economic expansion, even as inflation remains subdued. Risk assets could do well in such an environment, we believe.
We use the valuation of U.S. equities as an example. The earnings yield of U.S. equities—earnings per share divided by the share price—is the implied yield in earnings estimates that makes potential returns comparable to bond yields. This measure puts U.S. equity valuations in the richest quartile of their history, as the blue line indicates in the chart. Yet the earnings yield still looks cheap compared to historical bond yields, as the green line shows.
We see the world in a synchronized and sustained economic expansion, as detailed in our Global investment outlook: Midyear 2017. Eurozone growth has accelerated, and we believe any near-term worries on China are likely overstated. Yet overall we see an environment of structurally lower growth and interest rates. This suggests comparing today’s valuation metrics to past levels may not be as useful a guide to future returns as in previous cycles.
The current U.S. economic cycle has been unusually long, sparking fears that it is ready to die of old age. We compared this cycle with previous ones, based on estimates of economic slack, and found it has room to run. One consequence: A benign economic environment tends to go hand in hand with low market volatility. We see risks of policy missteps as the Federal Reserve plans to wind down its balance sheet and the European Central Bank looks to transition toward smaller asset purchases. A sharp rise in bond yields could undercut risk assets, but we expect both central banks will communicate clearly and proceed with caution.
Bottom line: We believe investors are being paid to take risk, and we prefer equities over fixed income. We like European, Japanese and emerging market shares, as well as the momentum factor. We are negative on major government bonds and prefer inflation-linked debt.
Read more market insights in my Weekly Commentary.