Three months ago, our view was that the US economy would grow slowly, with inflation and interest rates both remaining low. We also expected Europe would continue to struggle and believed that Chinese growth would accelerate.
Unexpected gains from US
From an economic perspective, the first quarter pretty much played out this way. The European economy is still contracting and Chinese growth (while erratic) looks set to come in at around 7.5% or 8% this year.
In the US, inflation remains low, hovering around 2% and interest rates appear to be on an uneven trajectory, but are slightly higher than where they were at the start of the year.
If we got anything wrong in our economic forecast, it was that we underappreciated the resilience of the US economy. We came into the year concerned about the effects of the fiscal cliff, but despite a significant tax hike, consumption levels thus far have held up better than expected thanks to an improving labour market and an ongoing resurgence in home prices.
We will not know exactly how fast the economy grew in the first quarter for another month, but the numbers will almost certainly be better than almost anyone expected they would be three months ago.
Looking ahead, we do think the economy will slow in Q2 as the effects of the sequester come into play more fully, but growth does appear to be strong enough to absorb the hit.
Equities: Stick with mega caps and emerging markets
One of the main themes we emphasised at the beginning of the year was that stocks would outperform bonds, with some of our specific preferences being for mega caps and emerging markets. Clearly, stocks have had an exceptional run to start the year and handily outperformed bonds.
We certainly don’t expect this pace of gains to continue, but even after the first-quarter rally, stocks still look inexpensive compared to fixed income alternatives, so we would continue to advocate overweight positions in equities. That said, however, we do expect volatility to be higher than it has been in the months ahead.
From a capitalisation perspective, mega-cap stocks have narrowly underperformed smaller caps, and we would advise investors to stick with a mega-cap bias. This area of the market continues to offer value and should benefit from solid corporate profits. Additionally, they remain a good defensive play in the event the Federal Reserve chooses to pull back on its asset-purchase program faster than expected since smaller-cap companies tend to have more exposure to changes in monetary policy.
One of our biggest misses so far this year was our preference for selected emerging markets, particularly China and Brazil. While Chinese growth has been accelerating, investors remain nervous about the financial system, and Brazilian economic growth has been disappointing.
Nevertheless, we retain our favourable views toward emerging markets and expect they will broadly outperform developed markets in the coming months.
Bonds: Focus on credit sectors
Three months ago, our fixed income outlook centred on our view that Treasuries and other government-related segments of the market looked risky and that credit areas such as high yield looked attractive. We also had a favourable view toward municipal bonds.
In general, this positioning proved to be correct and our outlook has not changed. Treasury yields have been mostly range-bound, but have moved slightly higher over the past three months and credit sectors of the market have outperformed.
Looking ahead, we would suggest investors continue to overweight credit sectors, but we would suggest a bit of caution when considering high yield – investors may want to take a closer look at bank loans, which offer attractive yields and can help protect against the effect of rising rates. Finally, we would encourage investors to stick with municipal bonds, which continue to look attractive, particularly in light of higher taxes.
