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Global economy: Stabilization, not stagnation

To treat the future with the deference it deserves, we believe that market forecasts are best viewed in a probabilistic framework. This article’s primary objectives are to describe the projected long-term return distributions that contribute to strategic asset allocation decisions and to present the rationale for the ranges and probabilities of potential outcomes. This analysis discusses our global outlook from the perspective of a U.S. investor with a dollar-denominated portfolio.

Since the end of the Global Financial Crisis, economic growth has fallen short of historical averages and consistently disappointed policymakers. Deflationary shocks have roiled the markets, and much of the world’s bond market offers negative yields. Some analysts still believe the world is headed for Japanese-style secular stagnation. And yet the modest global recovery — at times frustratingly weak — has endured, proving the most ardent pessimists wrong.

With forecasters having downgraded global growth outlooks for at least five consecutive years, we believe that the risks to the consensus outlook of 3% are more balanced this year. We anticipate “sustained fragility” for global trade and manufacturing, given China’s ongoing rebalancing and the need for structural business-model adjustments across emerging-market economies. We do not anticipate a Chinese “hard landing” in 2017, but we are more bearish than consensus on China’s medium-run growth prospects.

Our growth outlook for developed markets remains modest but steady. Increasingly sound economic fundamentals supported by U.S. and European policy should help offset weakness in the United Kingdom and Japan. For the United States, 3% GDP growth is possible in 2017, even as job growth cools. Our longheld estimate of 2% U.S. trend growth is neither “new” nor “subpar” when accounting for lower population growth and exclusion of the consumer-debt-fueled boost to growth between 1980 and the Global Financial Crisis.

Inflation: Global disinflationary forces waning for now Many developed economies will struggle to consistently achieve 2% core inflation due to a combination of depressed inflation expectations, excess capacity and structural falls in some prices associated with digital technology and excess commodity capacity in China and elsewhere. That said, some of the most pernicious deflationary forces are cyclically moderating. U.S. core inflation should modestly “overshoot” 2% in 2017, prompting the U.S. Federal Reserve to raise rates. U.K. inflation is also set to overshoot following the post-Brexit depreciation of sterling. By contrast, euro-area inflation will only return to target levels gradually.

Monetary policy and interest rates: Central banks grapple with their limits The U.S. Federal Reserve is likely to pursue a “dovish tightening,” raising rates to 1.5% in 2017 while leaving the federal funds rate below 2% through at least 2018.

Elsewhere, further monetary stimulus seems possible, but its benefits may be waning and, in the case of negative interest rates, potentially harmful to the very same credit-transmission channel that monetary policy attempts to stimulate. Even so, the European Central Bank (ECB) and Bank of Japan (BoJ) could yet add to the quantitative easing implemented in 2016.

Chinese policymakers have the most difficult task of engineering a “soft landing” by lowering real borrowing costs and the real exchange rate without accelerating capital outflows. The margin of error is slim, and policymakers should continue to provide fiscal stimulus to the economy this year to avert a hard landing. The most important policy measure we are monitoring is the pace of reforms for China’s state-owned enterprises, which are currently key sources of overinvestment and deflationary excess capacity.

Investment outlook: Muted, but positive given low-rate reality Our outlook for global stocks and bonds remains the most guarded in ten years, given fairly high equity valuations and the low-interest-rate environment. We don’t expect global bond yields to increase materially from year-end 2016 levels.

Bonds. The return outlook for fixed income remains positive yet muted. For example, our fair-value estimate for the benchmark 10-year U.S. Treasury yield still resides near 2.5%, even with two to three near-term increases in the policy rate. As we stated in 2015, even in a risingrate environment, duration tilts are not without risks, given global inflation dynamics and our expectations for monetary policy. Recent low volatility and compressed corporate bond spreads point to credit risks outweighing those of duration.

Stocks. After several years of suggesting that low economic growth need not equate with poor equity returns, our medium-run outlook for global equities remains guarded in the 5%–8% range. That said, our long-term outlook is not bearish and can even be viewed as positive when adjusted for the low-rate environment.

Asset allocation. Our outlook for portfolio returns is modest across all asset allocations when compared with the heady returns experienced since the depths of the Global Financial Crisis. This guarded but not bearish outlook is unlikely to change until we see a combination of higher short-term rates and more favorable valuation metrics. The investment environment for the next five years may prove more challenging than the previous five, underscoring the need for discipline, reasonable return expectations, and low-cost strategies.

Discipline is what it takes to block out the noise, commitment is what it takes to walk the path to financial success and patience is what it takes to reach the goal.

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