Global Asset Allocation Views 1Q18Contributor John Bilton
- Broad-based and above-trend growth is set to continue into 2018 before gradually easing back to trend over the year. Inflation is normalizing slowly, with limited risk of rising sharply as wages and oil prices remain contained. It may look too good to be true, but with growth strong and inflation modest, policymakers can focus on financial stability.
- Yet this is not a time for complacency. While the environment for taking risk is good, it is late in the cycle; keeping a close watch on macro data and maintaining a diversified portfolio across a liquid universe of assets are both essential. We see limited risk of recession in the next 12 months, but nevertheless trim further our credit exposures by taking U.S. high yield down to neutral, as we see better opportunities in stocks. We keep a broad regional diversification within equities, with Japan and emerging markets at the margin our most preferred regions.
- Yields are rising, and across sovereign markets we see muted returns from bonds in 2018; this, in turn, pushes those seeking income toward riskier assets. Nevertheless, we have only a small underweight to duration, as we believe that although the environment is currently benign, having a balanced portfolio is critical in successfully navigating the late-cycle economy.
“The view is great from the top!” it is often said. But it can also be pretty good from the foothills—with a bit less of the vertigo and sense of acute danger. So where are we today? The summit ridge or base camp? Many argue that nine years into a bull market we must be at the top. We disagree. While this is undoubtedly a long expansion and we believe that the U.S. economy is now in late cycle, we see few signs from either economic or financial market data that suggest we’re close to the peak. Of course, late cycle demands greater vigilance—just as ascending a headwall requires greater skill and diligence than a gentle walk in the hills—but objectively, today’s economy is supportive of further upside for asset markets.
Over the last 12 months, we have witnessed the best period of coordinated, above-trend global growth in almost a decade. Prevailing U.S. data on jobs, housing, confidence and business activity remain buoyant. Globally, the synchronous pickup in activity is pushing up trade data and looks set to accrue further to corporate earnings over the next year. Leading indicators suggest this pattern will continue in the first half of 2018. Yet the constructive economic backdrop is not without risks, and the greatest of these, in our view, would be an abrupt shift in today’s accommodative policy environment.
Central to whether this risk materializes is the path of inflation. We expect U.S. inflation to normalize, but see few risks of it rising meaningfully above the 2% target of the Federal Reserve (Fed)—a highly price-elastic shale oil supply, a relatively flat Phillips curve and the disinflationary effect of technology all limit the upside to inflation. In turn, our central case for monetary policy is that the Fed tightens in line with what it has communicated: a little more than is currently priced, but a lot less than would constitute a sharp tightening of policy. The same is true for most other central banks as policymakers globally focus less on the interplay between jobs and inflation, and more on the balancing act of maintaining financial stability while avoiding asset bubbles.
The economic and policy environment underpins a pro-risk tilt in our multi-asset portfolios, while the maturing cycle and sensitivity to monetary conditions reinforce a preference for a broad diversification of risk across more liquid markets. At this stage in the cycle, we see clear benefits from global diversification, as well as improving alpha opportunities—from both active asset allocation and security selection. Stocks are more positively geared to economic growth than credit, whose tight spread levels introduce some asymmetry to the risk-reward calculus. Nevertheless, although we expect rates to rise modestly, we still believe that a balanced portfolio of stocks and bonds will provide the best outcome—if equities are our crampons and axes, allowing returns to climb further, then bonds are our ropes and harnesses, essential to save us from a nasty slip.
Within our portfolios we remain moderately overweight (OW) equities; neutral credit, real estate and commodities; and slightly underweight (UW) duration. We favor a broad spread of risk across equity regions, but at the margin our order of preference is Japan and emerging markets ahead of the U.S. and Europe, with the UK and Australia our least preferred regions. We have trimmed U.S. high yield (HY) to neutral, reflecting our view that spreads are unlikely to tighten further and that equities offer a better risk-reward profile. We prefer U.S. Treasuries to German Bunds, as we expect the change in yields to be both gradual and quite similar, which means that the carry available from U.S. bonds is attractive relative to many other sovereigns. Overall, our portfolio attempts to balance a pro-growth view with the reality of a late-cycle environment.
The greatest risk for investors in navigating the maturing cycle may be exiting too soon. Historically, late-cycle equity returns are often significant and the opportunity cost of missing out can more than offset a drawdown that might be subsequently avoided. Running risk in this environment requires careful scrutiny of prevailing data, with particular attention to any turn in policy direction and any excesses building in positioning or sentiment. But something investors and armchair mountaineers alike might reflect on is that while summits may look sharp and jagged, up close they’re often much larger and flatter than they appear from afar. Most of all, both planting the flag at the top and a safe descent are of equal importance in a successful expedition.
KEY THEMES AND THEIR IMPLICATIONS
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