Tactical Asset Allocation - July 2023

Macro update

Following a quarter characterized by anemic growth, ongoing global monetary tightening, and a US yield curve that remains deeply inverted at levels not seen since the 1970s, US macro data surprised consensus with sizeable and widespread improvements across various economic sectors such as housing, manufacturing, and consumption, which recorded significant rebounds last month. Inflation data, while still high, remained broadly in line with market consensus. As discussed in our recent commentaries, historical evidence indicates the lagged effects of previous monetary tightening may still take time to filter through the economy. With that said, it has become increasingly evident the economy requires a much higher policy real rate to slow down employment growth, demand, and price pressures. US 2-year real yields from inflation protected securities (TIPS) are now at approximately 3%, levels last seen in 2006.² 

In response to these developments, risk appetite in financial markets has improved significantly and consistently over the last month, as evidenced by the outperformance of equities relative to fixed income, the broadly in-line performance of emerging markets relative to developed markets and the tightening of credit spreads across most fixed income sectors, from high yield, to emerging markets and quality credit. The magnitude of this reversal in market sentiment has historically signaled an improvement in growth expectations and a subsequent improvement in economic data. Our research indicates that the odds of a recession in the coming quarters are rapidly fading. Indeed, our macro picture shifts to a recovery regime for the global economy and its major regions, characterized by growth that is still low, below its long-term trend, but expected to improve in the near term (Figure 1 and Figure 2). 

These developments are reminiscent of the market dynamics experienced last December and in early 2023, when a noteworthy rebound in cyclical markets challenged the notion of imminent recession risk. As outlined then, we believe this recovery phase does not represent the start of a new economic cycle, given all-time lows in the unemployment rate, but another positive repricing of near-term growth expectations. This repricing can create meaningful opportunities from a tactical standpoint, especially in cyclical markets that have underperformed since the beginning of the year, in an environment so far driven by a leadership concentrated in a dozen stocks. We believe this cyclical rebound can continue in the coming months and warrants a repositioning of portfolio exposures.

Investment positioning 

With our framework transitioning from a contraction to a recovery regime, we increased risk in the Global Tactical Allocation Model and moved to an overweight risk stance relative to benchmark. We move from an underweight position to an overweight position in equities relative to fixed income, tilting in favor of emerging markets, cyclical sectors, value, and smaller capitalizations. We increased credit risk via lower quality sectors and maintain a neutral duration posture. We reduce exposure to the US dollar and move to an overweight foreign currency stance  (Figure 4, 5, 6, 7). In particular:

• Within equities we overweight cyclical factors with high operating leverage and a higher sensitivity to a rebound in growth expectations, such as value and smaller capitalizations, while we underweight defensive factors such as low volatility, quality, and larger capitalizations. We underweight momentum as inflection points in the market cycle tend to generate reversal effects between recent winners and losers. This style/factor rotation comes at a favorable time from a short-term valuation standpoint, as performance in equities year-to-date has been driven by a handful of quality mega-cap stocks, while cyclicals have meaningfully lagged the broad market index. Similarly, we favor exposures to cyclical sectors such as financials, industrials, materials, and energy at the expense of health care, staples, utilities, and technology. From a regional perspective, we overweight emerging markets, supported by improving risk appetite and expectations for US dollar depreciation. We maintain a neutral stance between US and developed ex-US equities, as growth momentum in Europe and Japan is weakening.
• In fixed income, despite the recent tightening in credit spreads, we overweight credit risk³ via high yield, bank loans and emerging markets hard currency debt. In this environment of below trend but improving growth, we expect volatility to remain subdued and credit markets to offer stable yield and total returns. Consequently, we reduce exposure to investment grade credit and government bonds and maintain a neutral duration stance. We expect further modest compression in breakeven inflation expectations, hence favor nominal over inflation-linked bonds, as inflation continues to decelerate (Figure 3).
• In currency markets we have reduce the exposure in the US dollar, as regimes of cyclical recoveries are typically accompanied by strong reflationary flows into non-US assets. While yield differentials still support the US dollar relative to foreign currencies, expensive valuations provide headwind to the greenback when safe-haven flows are abating. Within developed markets we favor the euro, the British pound, Norwegian kroner and Swedish krona relative to the Swiss Franc, Japanese yen, Australian and Canadian dollars. In EM we favor high yielders with attractive valuations as the Colombian peso and Brazilian real, relative to low yielding currencies as the Korean won, Taiwan dollar and Chinese renminbi.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.