We see reflation ? rising nominal growth, wages and inflation – accelerating globally in
2017, led by the U.S. This theme is central to how we suggest positioning portfolios
for the coming year, including our preference for value stocks over bond proxies.
Global value equities’ relative performance and U.S. Treasury yield curve, 2010-2016.
With inflation taking root and growth picking up, we believe bond yields have
bottomed, and yield curves are likely to steepen further in 2017. This environment
should support reflationary beneficiaries, such as value stocks. Higher long-term rates
drove a rotation within equities during the second half of 2016. Reflation contributed
to value shares outperforming the broader market, as bond-like equities suffered.
Stocks over bonds
We expect more of this rotation in 2017, and see the stock market beneficiaries of the post-crisis low-rate environment further
underperforming over the medium term. We generally prefer stocks over bonds and are optimistic about further upward revisions to
earnings estimates. Within equities, we favor U.S. regional banks, selected health care stocks and companies able to expand their
dividend payouts over time. Our research suggests dividend growers perform well when inflation drives rates higher.
On a regional basis, we have upgraded our views of Europe to neutral and Japan to overweight. Weaker currencies should support
these markets, though we are wary of political, policy and trade risks in the eurozone. We favor emerging market (EM) equities, given
structural reforms, improving profitability and low valuations. A sharp rally in the U.S. dollar or significant changes to trade agreements
are risks, however. We see earnings growth and further rotation into big sectors such as financials underpinning a U.S. stock market
advance in 2017, but we are cautious in the near term after large inflows and new record highs.
Within fixed income, a reflationary outlook challenges longer-term bonds. We favor shorter-duration bonds given their lower sensitivity
to rising rates. We see stronger growth supporting credit over government bonds, and we have a long-term preference for inflationlinked
securities over nominal debt.
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