As investors look into next year, it has become clear that while the backdrop has changed considerably from the early innings of 2020, there still exists great uncertainty. Once again, investors must ask: where are we in the recovery? Cyclical positioning can help to inform portfolio positioning, and given the building headwinds, having a firm grasp on the outlook is of vital importance.

The impact of the Covid-19 pandemic on the economy is fading in both directions — booster shots and anti-viral medications will allow for a continued return to normalcy, but the post- Covid-19 bounce-back in activity has largely run its course; a high probability of divided government in the U.S. following mid-year elections suggests that future fiscal stimulus will be limited; and, due largely to continued upward wage pressure, modestly higher inflation may linger. This economic cool down will impact corporations, which will face weaker demand alongside higher costs and a renewed interest in “social responsibility”; and the Fed will normalize. Meanwhile, global economic momentum looks poised to accelerate.

In other words, it seems that the U.S. economy is transitioning once more, shifting from “mid-cycle” to “late-cycle” conditions — trend growth, squeezed margins, rising inflation and tightening monetary policy; it should be noted, though, how unusual this cycle has been and will be, and despite this transition, there still seems to be room left to run for cyclicality in portfolios. International economies will be transitioning, too, though their respective cyclical positions will generally be less mature than in the U.S.; the global recovery has not been synchronized, as expected, but is rolling instead.

The natural next question, then, is: How should investors be positioned?

Ongoing global monetary policy tightening suggests that bond investors would be wise to shorten duration and could encourage additional risk-taking in fixed income. This may mean an increased allocation to lower-credit U.S. instruments, though the limited ability for spreads to compress further suggests instead a greater opportunity in foreign debt, particular in the emerging world.

From an equity perspective, investors should look primarily toward profitability. This favors an allocation to value stocks in the short term, as economic growth remains above trend. Outside the U.S., cyclically oriented international markets, like Europe and Japan, will benefit from the shifting global recovery, and could also offer investors an attractive hedge against inflation. Post-pandemic opportunities are also worth considering, particularly the emerging world and global technological innovation.

This changing backdrop may also push investors to further diversify portfolios. This suggests the need to consider a heartier allocation to alternatives, which are typically uncorrelated to public markets, and also explains the heightened interest in ESG investing, which can mitigate some — though not all — of the risks in capital markets.

Looking at portfolio positioning, this outlook has only partially been implemented. Fixed income allocations to low duration and extended credit bonds are both elevated; however, appetite for foreign debt remains depressed. In equities, a recent uptick in value allocation has only modestly impacted a strong overweight to growth; and while interest in non-U.S. stocks has risen going into 2022, it is no greater than it was in the beginning of 2021. Put another way, next year’s opportunities have not yet been fully embraced.

All told, the investing landscape continues to be complex. Given the nature of the ongoing global recovery and the shifting pockets of opportunity, the best way to approach asset allocation is to broadly diversify and work with active managers; likely more than in recent history, sector and security selection will be of paramount importance.