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Investment Viewpoint

Global Asset Allocation Viewpoints and Investment Environment: July 2018

T. Rowe Price

Market Themes

As of June 30, 2018

Trade Wars: Cease-Fire or Armageddon?

With trade wars escalating, markets are becoming more concerned about when and how it all ends. For now, the U.S. and China appear locked in a tit-for-tat escalation of tariffs, with the European Union and Canada joining the battle by retaliating with targeted tariffs on U.S. goods, and NAFTA undergoing renegotiation. While the U.S. economy is less reliant on trade than most of its trade partners, targeted tariffs could have significant impacts on certain U.S. sectors and companies. For certain, tariffs raise costs, can pressure margins and result in higher prices. While the U.S. may feel it has the upper hand given its trade deficits with China and the EU, tariffs are not the only weapons available—targeted actions on foreign companies, unwinding U.S. treasury holdings and currency manipulation do not seem out of scope. While it is difficult to gauge the impacts on markets given the current dynamics, things could certainly get a lot worse with battles opening on multiple fronts and the choice of weapons expanding.

A Scorching Summer Ahead for EMS?

Emerging markets debt, equity and currency markets are feeling the heat from a growing list of concerns. With the recent escalation in trade wars, investors are selling emerging markets assets as uncertainty over the outcome grows. Beyond trade wars, liquidity has fallen as developed market central banks—led by the Fed—unwind accommodation, the U.S. dollar has strengthened and interest rates are higher. Some emerging countries are already being forced to raise rates to defend their currencies. With several upcoming key elections, a resilient U.S. Fed and no end in sight on trade wars, it may be a scorching summer for a few emerging markets countries. On the bright side, the broad sell-off seems to have priced in much of the risks and some less vulnerable countries are looking attractive.

What Could De-Throne Growth (Stocks)?

Continued strong relative performance in the technology and consumer discretionary sectors has helped advance a multi-year lead for growth relative to value stocks. Since the end of 2014, growth-oriented stocks in the U.S. are up nearly 50%, more than tripling the return of value stocks. Growth stocks have undoubtedly benefited from the low growth economic environment where investors sought “durable growers” in lieu of more cyclical sectors, but they have also delivered vastly superior earnings growth. However, the advance has been primarily driven by a narrow list of technology-oriented companies that now hold elevated valuations. Trade wars may cause investors to question these elevated valuations, with technology supply chains vulnerable to escalation of the U.S.-China trade dispute.

Portfolio Positioning

  • We increased our underweight to equities as valuations remain elevated against a backdrop of receding global liquidity, higher rates, an aging U.S. economic cycle and rising trade tensions. While valuations are more attractive than levels seen at the start of the year, key factors that supported earnings, including tax reform, a weaker U.S. dollar and higher energy prices will likely be less of a tail-wind going forward.
  • We trimmed our overweight to developed markets outside the U.S. amidst signs of moderating growth, rising trade tensions and resurgence in political risk. Valuations outside the U.S. are modestly more attractive and the regions are still supported by monetary policy, however economic growth momentum looks to have peaked near-term.
  • We reduced our overweight to value stocks outside the U.S. as catalysts for cyclical sectors to outperform have moderated along with growth expectations. Escalating trade wars, a resurgence in political uncertainty and weakness amongst European financials—a key support for regional growth—all pose headwinds.
Fixed Income
  • We initiated a modest overweight to long-term U.S. treasuries to mitigate overall risk within our portfolios. Long-duration treasuries can potentially provide efficient downside protection against equity market drawdowns.
  • We are underweight to high yield bonds as valuations appear elevated late in the credit cycle amidst high leverage and likely fading support from the recent strong trend in earnings and energy prices.
  • We favor floating rate loans relative to high yield bonds. With the Fed expected to continue raising rates this year and possibly into 2019, loans should benefit from their rate reset feature and shorter duration profile.
  • We are underweight emerging market-dollar bonds due to risks from rising developed market rates, protectionist trade policies, and increased political uncertainty amongst several key countries.
Real Assets
  • We remain underweight real assets equities as we are still cautious on the long-term prospects for energy and commodity prices, given continued advances in productivity growth and fading Chinese demand for industrial metals.
  • OPEC’s recent agreement with other producers to increase supply by as much as 1 million barrels per day could help moderate supply outages in several countries, including Venezuela and Libya.
  • REIT fundamentals are broadly positive, with muted supply growth and healthy levels of occupancy and rental income. However, rising rates may pose a near-term headwind.

Past performance is not a reliable indicator of future returns.

Sources: FactSet Research Systems, All Rights Reserved, J.P. Morgan, [IMF]/Haver Analytics.

1Indices used: EM Stocks = MSCI Emerging Markets Index, EM Bonds = JP Morgan EMBI Global Index, EM Currency = JP Morgan EM Currency Index

T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved.

Regional Backdrop

As of June 30, 2018

United States

  • In the later stages of the economic cycle, with recession risks low but rising
  • Pro-cyclical policies of tax reform and deregulation offer near-term support, but late cycle stimulus may result in overheating
  • Inflation gradually rising amid tighter labor markets, with added pressure from higher oil prices
  • Aggressive trade policy poses a significant and growing risk, but may ultimately be limited in scope
Equity Fundamentals
  • Valuations above historical averages, with significant bifurcation between winners and losers
  • Earnings are very strong, but current pace of growth unlikely to be sustainable
  • Margins could face headwinds from higher rates, wages and input costs
  • Earnings disappointments are being harshly punished
Interest Rates
  • Short-term rates rising in unison with Fed rate increases, could extend into 2019
  • Longer rates volatile, but biased higher over the long term amidst improving growth, rising inflation expectations, expanded budget deficit, and Fed balance sheet unwind
  • Stabilization of global growth, tighter monetary policy outside the U.S. and valuations are likely headwinds to the medium-term outlook for the dollar
  • The dollar has continued its strong performance of late, partly driven by softer growth outside of the U.S. Higher relative yields in the U.S. also remain supportive

Developed Europe

  • Eurozone growth moderating, but expected to stabilize and remain above potential
  • Rising trade protectionism is a significant risk, most notably for Germany given its export focus
  • While off their highs, Italian yields remain elevated after the formation of the government, as the market awaits its economic policies
Equity Fundamentals
  • Valuations are modestly attractive relative to the U.S.
  • Operating leverage provides for further earnings upside potential, with the recent uptrend in earnings expected to continue
  • European banks showing significant weakness both on an absolute basis and versus other sectors
Interest Rates
  • Sustained growth, recent euro weakness, and further evidence of rising inflation could gradually push rates higher
  • Recent Italian political events, the lack of progress/acceptance of the Macron reforms to reinforce the Eurozone, and the tension over immigration have re-introduced concerns regarding the sustainability of the E.U.
  • Political risks, ECB policy, and still lackluster data flow, continue to restrain the euro versus the U.S. dollar
  • Valuations remain attractive from an exchange rate perspective, and the medium-term economic and ECB policy trajectories remain positive, albiet weakened, drivers

United Kingdom

  • Brexit negotiations remain the central issue for growth trajectory
  • The UK parliament has passed the European Withdrawal Act, which provides for the passage of the UK out of the EU’s legal, but not economic or customs, union
  • UK inflation has declined to its lowest level in a year (2.4%), contributing to higher real wages
Equity Fundamentals
  • UK valuations continue to trade at a discount to other markets
  • Domestically-driven revenues remain disappointing
  • Allocations to UK equities by global investors are at extremely low levels
Interest Rates
  • Bank of England signaling support for a rate rise in August, stating that the UK appears to be coming out of its early 2018 weak patch
  • Over the longer-term, rates will remain dependent on Brexit negotiations and inflation outlook
  • A slightly more hawkish BOE than expected has supported Sterling versus European counterparts of late, although it has weakened vs. the U.S. dollar
  • However, despite this and attractive valuations versus history, concerns remain over the long-term political and economic outlook into and out of Brexit

Developed Asia & Pacific

  • Trade-driven economies likely to slow as global growth appears to have peaked—though growth remains at healthy levels
  • Slowdown in Japan continued although some confidence metrics and leading manufacturing indicators are pointing higher
  • Significant improvement in Prime Minister Abe’s approval ratings suggest a stable macro policy outlook for now
  • Australian economic activity improved from last year with net exports and government spending the main contributors
  • Easing tensions on the Korean Peninsula may reduce uncertainty in the region
Equity Fundamentals
  • Valuations within the region remain attractive relative to other developed markets, but earnings remain vulnerable to currency and commodity price volatility and a slowdown in global trade
  • Japanese equities remain supported by better relative valuations, strong earnings growth, and gradually improving corporate governance
  • Australian equities enjoying a period of strength, driven by mining sector—however, valuations are beginning to appear stretched
Interest Rates
  • A continued rise in global yields could impact long rates in the region
  • The Bank of Japan continues to reaffirm its accommodative policy, with no change expected in the near-term amid benign inflation
  • RBA likely to remain on hold with wage growth subdued and inflation below target
  • Recent risk-off driven strength has moved the yen to the midpoint of its range over the past year
  • On a medium-term view, the yen remains cheap and external positions are supportive, however U.S. policy and risk sentiment, rather than domestic fundamentals are the current drivers
  • The Australian dollar has weakened to relatively cheap levels recently due to interest rate differentials and global trade concerns

Emerging Markets

  • Growth is slowing but not collapsing, likely to stabilize in the latter half of 2018
  • Trade protectionism a growing risk, but real impact should be limited as long as the dialogue between U.S. and China continues
  • Trade war concerns and anticipated economic slowdown should keep Chinese macro policies supportive in the short term. Growth is slowing but remains actively controlled
  • Idiosyncratic and political risks remain elevated in several key countries— including Mexico, Brazil, Argentina, Venezuela, Malaysia and Turkey
Equity Fundamentals
  • Valuations considerably more attractive, as equities have sold off on trade concerns, U.S. dollar strength, and elevated country-specific risks
  • Demand for exports is healthy but fading
  • Earnings growth remains broadly strong, with ROEs broadly improving
Interest Rates
  • Interest rates trending higher as financial conditions tighten in response to rising inflation and higher U.S. rates
  • Many central banks have shifted from accommodative/neutral to a tightening bias
  • EM currency valuations have cheapened due to a stronger USD, idiosyncratic factors and notable outflows
  • U.S. rate policy, global growth, politics and trade will continue to be the major areas of focus for EM

Asset Allocation Committee Positioning

As of June 30, 2018

Portfolio Implementation

As of June 30, 2018

1U.S. Small-Cap includes both Small and Mid-Cap allocations.

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 J.P. Morgan index data - Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2018, J.P.

Morgan Chase & Co. All rights reserved.

Source for Bloomberg Barclays index data - Bloomberg Index Services Ltd. Copyright© 2018, Bloomberg Index Services Ltd. Used with permission.

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.

Copyright © 2018 FactSet Research Systems Inc. All rights reserved.

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—Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S. Securities and Exchange Commission. For Institutional Investors only.

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.



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