SINGAPORE (Apr 19): Strong global demand should continue to fuel capital expenditure spending and trade but growth momentum for the global economy is moderating, says JP Morgan Asset Management (JPMAM) in its market outlook for the second quarter of 2018.

Dr Jasslyn Yeo, Global Market Strategist at JPMAM, says: “We see a broadening growth recovery in 2018, with the developed markets of the US, Eurozone and Japan growing above trend, led by strong market demand fuelling capex and trade recovery.”

She expects some moderation in growth in the second half of the year, but this is a natural progression after a period of above-trend growth.

Yeo notes: “Output gaps are closing and moving into positive territory, which suggest that the developed economies are now operating at or past their full capacity. Wage growth is expected to rise, but we believe inflation is unlikely to accelerate in a big way due to structural disinflationary forces.

“The Fed’s reaction to rising inflation will be key. We expect it to respond with gradual rate hikes, specifically we see another three rate hikes this year, bringing the Fed funds rate to 2.5% by year-end. We do not believe that the Fed is making a policy mistake. Financial conditions remain accommodative and the real Federal funds rate is still negative.”

While protectionism in the global economy is rising in response to widening income inequality and this remains a longer-term trend, Yeo expects trade risks to de-escalate as US-China negotiations take place.

She reckons that a likely outcome will be a watered-down version of recent tariff announcements and the economic impact will be relatively moderate. China will likely reduce tariff rates on US exports (e.g. autos) and increase imports from the US (e.g. US oil & gas and agricultural products) to reduce the US-China trade imbalances and also further open up its markets. The Renminbi and/or US Treasuries are unlikely to be used as retaliatory instruments.

Yeo notes that the markets have seen a shaky start to 2018, causing investors to remove their rose-tinted glasses as they begin to see downside risks to growth and upside risks to inflation.

She says: “The US is in the late stage of economic expansion and asset class valuations are challenging. Going forward, investors should expect lower returns on fixed income and equities as rates and bond yields rise, and higher market volatility as macro uncertainty increases.”

JPMAM prefers equities over fixed income on strong earnings growth but recommends investors reduce the size of their equity positions in the wake of macro uncertainty and higher volatility. They should also start diversifying into income strategies if bond yields rise above 3% and growth momentum slows.

Yeo suggests that investors keep a lookout for wide moat companies which have a sustainable competitive advantage amongst their rivals in the market. Companies with good pricing power, effective cost management and stronger balance sheets will have better ability to protect profit margins and defend market share in a rising wage and interest rate environment.

She adds: “For 2Q18, while we see room for a relief rally as trade tensions subside, the risk of a market correction is still high, but the risk of a bear market is low. Some of the red flags investors should watch out for an equity bear market would be if earnings fail to deliver, yield curve inverts and significant widening of credit spreads.”

Currently, JPMAM prefers US and Emerging Markets/Asia ex-Japan over European equities and cash to government and investment grade bonds. It believes that bonds are less effective as a hedge in portfolios with stock-bond correlations becoming less negative. It also believes that the US dollar has found a temporary floor and can stage a rebound.

In the high yield space, JPMAM remains selective on high yield bonds and notes that emerging market debt is more resilient this time compared to the taper tantrum.