The third quarter of the year saw a surge in the US dollar and fall in commodity prices causing investors to question the sustainability of the global recovery and the rally in equity markets. There are fears that the drop in commodity prices is a harbinger of much weaker economic growth and that the move in the dollar is symptomatic of a search for safe havens. Long rates remain low and bond markets appear to offer a more pessimistic view of global growth than their equity counterparts.
The growth picture is certainly mixed: the recovery in the Eurozone and Japan has faltered, whilst activity in China remains tepid. Only the US seems to have been able to shrug off earlier weakness with a strong rebound in the second and third quarters of the year. From this perspective, the move in the US dollar is a natural consequence of divergent macro cycles, a development we would see as overdue and helpful to the world economy. In a world of sluggish growth, currency moves redistribute demand and the depreciation in the euro and Japanese yen will provide reflation to two areas fighting deflation.
The fall in commodity prices may well reflect the weakness of global demand, but supply side factors such as buoyant harvests and unexpected increases in crude oil production have also played a role. Although commodity producers will be hit by lower prices, the fall in the cost of food and energy is a benefit to the consumer, acting like a tax cut. In a world where households are unwilling to leverage, consumer spending is primarily driven by fluctuations in real income and so the move in food and energy should spur stronger spending in coming months.
Consequently, we still believe that equities offer the most attractive risk premium, nonetheless we do see reasons to cut our exposure to risk assets by trimming our overweight equity position, through a reduction in emerging markets. We discuss the factors driving the equity-bond choice and the implications of the stronger dollar below. We also look at the global cycle in asset allocation and, taking a step back from the short run, have included our return projections for the next seven years.
Keith Wade, Chief Economist and Strategist, Schroders
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