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Investment Viewpoint

First Quarter 2018

Asset Allocation Committee Viewpoints

T. Rowe Price

Market Themes

Growth Momentum Poised to Extend Into 2018

Broad-based global growth momentum continues into 2018, supported by strength outside the U.S., notably in Europe and Japan. Tax policy changes in the U.S. could provide a near-term boost to U.S. profit growth next year, while the longer-term economic impact is less certain. Emerging markets growth could be buoyed by higher commodity prices and improving global trade. Stronger macro backdrop has translated into positive earnings momentum across many regions, particularly Europe, Japan, and emerging markets.

U.S. Dollar May Become a Headwind

The U.S. dollar (USD) finds support after declining for much of the year against major developed and emerging market currencies. Despite higher short-term rates resulting from the Fed’s steps toward rate normalization, the U.S. dollar declined through most of 2017 as growth and inflation expectations outside the U.S. improved. The weaker dollar has been a major support for emerging markets, commodity prices and U.S. multi-national companies which may now find the currency a headwind. So too will U.S. dollar-based investors who have seen their foreign asset returns inflated by currency gains this year.

Central Banks May Finally See (Modestly) Higher Inflation

Stronger global growth, tighter labor markets and more stable commodity prices may finally begin to push inflation higher next year providing further support for central banks already unwinding policy. The U.S. Federal Reserve is well into its stimulus reduction process and the European Central Bank recently announced plans to halve its asset purchases beginning next year. The Bank of Japan remains the furthest from achieving its goal, but has been quietly reducing its bond purchases and may modify its target for yield curve control. Emerging markets may also turn more hawkish next year amidst stronger growth and higher inflation.

Portfolio Positioning

Equity
  • We remain modestly underweight equities as valuations are extended and earnings growth expectations appear elevated against a backdrop of improving, yet still modest economic growth and potential for increased volatility as central banks cautiously reign in policy.
  • Within capitalization, we increased our overweight to U.S. small-cap stocks based on attractive relative valuations and potential benefits from lower corporate tax rates.
  • Within style, we are overweight value-oriented stocks outside the U.S and neutral within the U.S., as signs of more durable and synchronized economic growth, higher interest rates and stabilization in commodity prices should provide support for more cyclical sectors.
Fixed Income
  • We moved to an underweight emerging market bonds due to less compelling valuations (Figure 1) and increased political uncertainty amongst several key countries, including Mexico, Turkey, Brazil and South Africa that collectively make up more than 25% of the market. (Figure 2)
  • Within EM bonds we favor local currency bonds as select countries may see further upside potential from their currency appreciation.
  • We remain underweight high yield bonds as valuations offer limited upside potential from current levels, although fundamentals remain supportive and defaults are expected to remain at low levels. Tax policy impact is mixed as interest deductibility could weigh, while muted supply could provide support.
Real Assets
  • We remain underweight real assets equities as we are still cautious on the prospects for energy and commodity prices, given continued concerns over supply and demand imbalances.
  • Despite the recent rise, energy prices are likely to remain challenged by rapid production increases and lower input costs among U.S. shale producers.
  • Industrial metals prices remain structurally challenged by oversupply and demand as China continues on a slower growth path.
  • After lagging broader markets, REITs appear fairly valued relative to earnings expectations and trade at a modest discount to private market net-asset values. Fundamentals remain broadly positive, supported by improving economic environments and limited supply.

FIGURE 1: EM Debt1 Yield to Worst

Fifteen Years Ending December 31, 2017

1Based on the J. P. Morgan Global Emerging Markets Bond Index.
Sources: J. P. Morgan.

FIGURE 2: EM Debt1 Index Weights by Country

As of December 31, 2017

1Based on the J. P. Morgan Global Emerging Markets Bond Index.
Sources: J. P. Morgan.

Regional Backdrop

As of December 31, 2017

United States

Macro-Economic
  • In the later stages of the economic cycle, but recession risks remain low
  • Inflation likely to trend higher supported by tight labor market
  • Tax reform and deregulation offer a potential near-term catalyst
  • Monetary policy unwind continues but at very measured pace
Equity Fundamentals
  • Valuations trending above historical averages
  • Earnings growth expectations are elevated, offering limited room for upside surprise
  • Tax reform likely to provide a near term boost to 2018 earnings
  • Margins may face headwinds from higher interest rates and wages
Interest Rates
  • Valuations trending above historical averages
  • Earnings growth expectations are elevated, offering limited room for upside surprise
  • Tax reform likely to provide a near term boost to 2018 earnings
  • Margins may face headwinds from higher interest rates and wages
Currencies
  • USD supported by rate differential reinforced by improving economic growth and near-term boost from tax reform
  • Extended economic cycle and wide non-oil external deficits are structural headwinds

Developed Europe

Macro-Economic
  • Eurozone business cycle is in earlier stages as compared to the U.S., with growth trending above potential, benefitting from improving global trade
  • Political risks remerge with Merkel’s difficulties in forming a coalition in Germany. Brexit negotiations and Italian elections in 2018 remain a source of uncertainty
  • ECB takes dovish first steps toward tapering
Equity Fundamentals
  • Valuations are modestly attractive relative to the U.S., provided earnings continue to rebound
  • Operating leverage provides for further earnings upside potential, with the recent uptrend in earnings expected to continue
  • Financials in the periphery are challenged, but improving
Interest Rates
  • Rates largely unchanged as ECB signals a modest downshift in policy accommodation
  • Sustained growth and further evidence of rising inflation could gradually push rates higher
Currencies
  • Improved economic outlook and potential ECB action expected to be positive drivers over the near to intermediate term
  • Cheap valuations are supportive of longer term strength

United Kingdom

Macro-Economic
  • Heightened uncertainty from Brexit negotiations likely to weigh on business confidence
  • Elevated inflation, driven by currency weakness, could weigh on consumer spending
Equity Fundamentals
  • Valuations relatively attractive following underperformance, high dividend yield
  • Exporters may benefit from pound weakness
  • Domestically-driven revenues remain disappointing
Interest Rates
  • BoE raised its base rate by 0.25% to 0.50% in November 2017, the first rate hike in a decade, citing higher inflation
  • Stabilizing inflation and subdued growth may diminish pressure on BoE to continue raising rates
Currencies
  • BoE may be on hold after single rate increase, softening support for the pound. Expect volatility around Brexit negotiations
  • Longer-term outlook is challenging and uncertain given concerns over post-Brexit growth

Developed Asia & Pacific

Macro-Economic
  • Most economies benefiting from leverage to global growth and trade
  • Japanese monetary and fiscal policy remain tailwinds, despite some concerns at the BoJ regarding the negative impacts of the extended easy policy
  • The tight labor market is not yet filtering through to wage growth and consumption spending in Japan, where structural challenges remain daunting
  • Australian growth is set to accelerate in 2018 on the back of the synchronized global growth and Chinese demand for higher quality commodities
Equity Fundamentals
  • Japanese valuations are relatively attractive despite the recent rally; Australian valuations are also compelling and offer relatively attractive yield
  • Margins and earnings have upside potential, but remain vulnerable to currency and commodity price volatility
  • Japanese corporate governance and shareholder returns are improving, but gradually
Interest Rates
  • Rates may trend higher as BoJ acknowledges fewer bond purchases and may look to modestly increase target for yield curve control
  • Japan’s stubbornly low wage growth contributes to benign inflation outlook, keeping yields anchored for the near term
  • Regional yields are at risk to move higher due to exogenous factors such as the US yield curve
Currencies
  • Yen mostly driven by actions of other major central banks while BoJ remains anchored
  • Aussie dollar susceptible to a pullback in commodities, but likely to remain stable

Emerging Markets

Macro-Economic
  • Emerging market growth differential relative to developed economies should improve further on the back of the global recovery
  • Lower inflation has provided latitude for EM central banks to be accommodative, but may become a headwind next year
  • Chinese growth likely to trend modestly lower as President Xi Jinping’s government emphasizes quality over quantity
  • Cautious of rising idiosyncratic and political risks in several key countries – including Mexico, Brazil, South Africa and Turkey
Equity Fundamentals
  • Commodity and energy prices have provided stability to commodity exporters—but remain a risk
  • Earnings boost from technology sector may be fading
  • Relative valuations modestly attractive versus developed markets yet elevated to own history
Interest Rates
  • Interest rates likely to trend higher as central banks respond to stronger growth, increasing inflation and higher U.S. rates
  • Significant inflation disparity to remain between commodity producers versus commodity consumers
Currencies
  • Broadly cheap valuations are supportive, but near-term headwinds could grow if central banks become less accommodative or Chinese growth softens
  • Oil-sensitive currencies such as the Malaysian ringgit have scope to benefit from recent strength in oil prices

Asset Allocation Committee Positioning

As of December 31, 2017

Portfolio Implementation

As of December 31, 2017

Source: T. Rowe Price.
Information presented herein is hypothetical in nature and is shown for illustrative, informational purposes only. It is not intended to be investment advice or a recommendation to take any particular investment action. This material is not intended to forecast or predict future events and does not guarantee future results. These are subject to change without further notice. Figures may not total due to rounding. Neutral equity portfolio weights representative of a U.S. biased portfolio with a 70% U.S. and 30% International allocation; includes allocation to real assets equities. Core fixed Income allocation representative of U.S. biased portfolio with 55% allocation to U.S. Investment Grade.
Additional Disclosures:
Source for MSCI data - MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.
Source for Bloomberg Barclays index data - Bloomberg Index Services Ltd. Copyright© 2017, Bloomberg Index Services Ltd. Used with permission.
1 U.S. Small-Cap includes both Small and Mid-Cap allocations.

IMPORTANT INFORMATION
This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

USA: For Institutional Investor Use Only. T. Rowe Price Investment Services, Inc. and T. Rowe Price Associates, Inc.

T. ROWE PRICE, INVEST WITH CONFIDENCE and the Bighorn Sheep design are, collectively and/or apart, trademarks or registered trademarks of T. Rowe Price Group, Inc. All rights reserved.

201801-347299

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