At the conclusion of the summit, we released the following report:
Asset allocation views
The start of 2016 saw the post-global financial crisis (GFC) expansion enter its seventh year; U.S. GDP grew for the 20th straight quarter and continues to expand despite volatility. Yet on many metrics, sentiment is fragile: High yield spreads hit a post-crisis high of 839 basis points (bps), oil fell to a 13-year low of $26/bbl, and global equities flirted with a bear market. We maintain our expectations of subdued growth but no recession, and note that equity bull markets are often seen to “climb a wall of worry.” But this is no ordinary wall of worry. So despite our conviction in low but positive growth, we adopt a cautious tone, seeking out carry over capital growth, quality over apparent cheapness and relative value over directional bets.
Our positive view of growth should be supportive for stocks, but nominal growth is too low and valuations too high to ignore worsening financial conditions and increasing tail risks. The U.S. and Europe look set to grow slightly above trend, but persistent weakness in emerging markets (EM) will weigh on global growth. The good news is that the worst of the EM contraction is likely behind us; but equally, excess global capacity and debt continue to dampen inflation and aggregate demand—in turn constricting nominal growth.
Some of the recent market turmoil can be traced back to policy divergence and waning confidence in central banks. Anxieties around the start of the U.S. hiking cycle in the face of lackluster growth were an acute issue early in the year, but these are dissipating as the Federal Reserve (Fed) moderates its path of hikes to balance U.S. domestic strength with global vulnerabilities. The case for positive growth in 2016 is underpinned by the strength of U.S. consumption, household balance sheets and the labor market. However, it is becoming clear that monetary stimulus alone is a stabilizer, not an accelerant; other factors, such as incentives for corporate investment or increased fiscal support, will be needed to further boost growth—and these do not seem to be imminent. A key issue is that prior policy action borrowed returns from the future, and now that future is here. So, while recession risk is low, we anticipate a period of sluggish growth and muted returns. Yet a more cautious view on asset returns does not mean a lack of opportunity. Indeed, recent volatility has reinforced many of our themes and presented dislocations and opportunities.
We make two key changes to our active allocation views: We take our relative view on stocks vs. bonds down to neutral and increase our positive view on credit. An environment of low but positive growth, together with relative valuations of credit and equity, implies equity-like returns from high yield credit and makes it an attractive proxy for stocks. We remain neutral on duration and see U.S. 10-year Treasury yields in a lower range of 170–230bps, commensurate with two Fed hikes in 2016. We also stay neutral on commodities and mildly negative on cash.
At a more granular level, we are overweight (OW) U.S. large cap equity; high yield credit (primarily as a substitute for equities); Europe ex-UK equity; U.S. and Australian government bonds; and the U.S. dollar. We are underweight (UW) U.S. small cap equity; Japanese stocks; emerging market debt; German, Canadian and UK government bonds; euro and sterling. We remain UW emerging market equity, but at a reduced level.
The path of the U.S. dollar remains a key consideration. We expect some residual strength but see the dollar consolidating by mid-year as the market prices in the Fed’s glacial path of hikes. If more-stable and uniform global growth aids dollar consolidation, that would signal increased risk appetite and a better outlook for emerging markets. But if the dollar falters because of sputtering U.S. growth, the outlook would darken for risk assets generally. Ultimately, we remain optimistic about global growth and anticipate a more virtuous end to the dollar cycle, but the risks to this core view reinforce our more cautious allocation stance.
Credit risk is the risk that issuers and counterparties will not make payments on securities and investment held by the portfolio. Such default could result in losses to an investment in the portfolio. In addition, the credit quality of securities held by a portfolio may be lowered if an issuer's financial condition changes. Lower credit quality may lead to greater volatility in the price of a security. Lower credit quality also may affect liquidity and make it difficult for the portfolio to sell the security. The portfolio may invest in securities that are rated in the lowest investment grade category. Such securities are considered to have speculative characteristics similar to high yield securities, and issuers of such securities are more vulnerable to changes in economic conditions than issuers of higher grade securities.
The prices of equity securities are sensitive to a wide range of factors, from economic to company-specific news, and can fluctuate rapidly and unpredictably, causing an investment to decrease in value.
Securities rated below investment grade are considered "high-yield," "non-investment grade," "below investment-grade," or "junk bonds." They generally are rated in the fifth or lower rating categories of Standard & Poor's and Moody's Investors Service. Although these securities tend to provide higher yields than higher rated securities, they tend to carry greater risk.
International investing involves a greater degree of risk and increased volatility due to political and economic instability of some overseas markets. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can affect returns.