Tactical Asset Allocation – Monthly Update

Our framework continues to suggest the global economy is in a slowdown regime, defined by growth above its long-term trend, albeit decelerating. Global risk sentiment continues to balance counteracting forces. While a robust economic and corporate earnings backdrop remains largely supported by the continuation of the artificial intelligence (AI) supercycle buildout, geopolitical and inflation-related risk lingers, resulting in ramifications for central bank policy globally. This tug-and-pull remains apparent in risk assets: The risk-return relationship between asset classes is becoming increasingly complex as higher yields have begun to challenge the growth proposition offered by equity markets. The resulting consolidation of global risk sentiment reinforces our position to remain diversified and hedge growth risks while preserving risk-on optionality. Therefore, we maintain an overweight to equity risk relative to fixed income, with an emphasis on diversification between and within asset classes.

Our macro process drives tactical asset allocation decisions over a time horizon between six months and three years, on average, seeking to harvest relative value and return opportunities between asset classes (e.g., equity, credit, government bonds, and alternatives), regions, factors, and risk premia.

Macro update: Resilient growth, elevated uncertainty

The growth tailwinds stemming from the AI supercycle remain intact when viewed through the corporate earnings lens. Despite concerns that AI-related spending has become excessive, fundamental earnings continue to suggest that profitability and monetization of the AI buildout outweigh AI infrastructure-related cost concerns. As of the end of the second-quarter earnings results, cohorts of the Magnificent 7 have delivered earnings growth of 118.5%, which is the strongest since Q4 2021. Importantly, beneficiaries of the AI buildout are broadening too. The other 493 companies in the S&P 500 have generated nearly 32% earnings growth in the second quarter, also the strongest since late 2021.

Geopolitical risks remain elevated and cannot be discounted as the US-Iran conflict has dragged into its sixth month. While the intensity of strikes between both sides appears to have eased for the moment, the current uneasy stalemate has resulted in a state of protracted war, characterized by limited attacks and, importantly, little progress toward restoring traffic through the Strait of Hormuz to pre-conflict levels. As a result, tanker traffic through the Strait remains stalled, causing energy prices to remain meaningfully higher. The path forward remains highly uncertain. The timing of any resolution, the pace of rebuilding energy infrastructure, and the extent to which supply constraints ease all remain key risks. 

Economic growth remains resilient. Led by the US, our measure of global economic growth, based on leading economic indicators, continues to register above trend. Strong consumer spending, which comprises about two-thirds of US economic activity, is coinciding with historic levels of business investment fueled by the continued AI buildout. Developed non-US economies also remain above trend, with similarities to the US, including stronger readings of consumer sentiment and business surveys. As a result, our framework remains in a slowdown regime, reflecting above-trend global economic growth alongside a continued deceleration in global risk appetite (Figures 1a, 1b, 1c, 2).

Inflation momentum remains contained, despite energy prices remaining elevated (Figure 3). While the overall level of inflation remains relatively higher, recent energy price volatility remains below levels experienced earlier this year. With respect to the level of inflation over the month, the core Personal Consumption Expenditures Price Index (PCE), which measures overall price changes for goods and services purchased by consumers, excluding the more volatile food and energy components, registered at 3.6% in the second quarter, marking the 22nd month of above-2% target readings. 

Fed Chairman Kevin Warsh focused on above-target inflation during his widely anticipated remarks at the Jackson Hole Economic Symposium, where he struck a hawkish tone and reconfirmed the Federal Open Market Committee’s (FOMC) intolerance of the current level. His remarks translated into interest rate market pricing, with the short end of the yield curve reflecting greater confidence in near-term rate hikes, while the long end of the yield curve declined, calming credibility fears priced in earlier this month. Overall, higher yields, both nominal and inflation-adjusted, remain elevated and represent a combination of multiple forces. They include monetary policy uncertainty, potential fiscal spending concerns, geopolitical and resulting inflation risks, a higher economic growth environment, and supply considerations from issuers selling greater amounts of long-term debt. As a result, higher yields present an opportunity for multi-asset investors, as the prospective return per unit of risk is increasingly attractive relative to other, riskier investment options, while the diversification opportunities in a total portfolio context remain intact.

In summary, the current mix of above-trend economic growth and a modestly decelerating trend in risk sentiment supports a continuation of the slowdown regime. While this environment doesn’t point to an immediate cycle-ending contraction, the current mix of elevated geopolitical risks, resilient corporate earnings, a healthy US consumer, and an increasingly complicated inflationary backdrop warrants an emphasis on portfolio diversification. Historically, periods of above-trend but slowing growth have been associated with modestly positive returns across asset classes, along with performance convergence between growth-sensitive and defensive assets. This convergence continues to shape our tactical view and is reflected in the balanced and targeted investment positioning outlined below (Figures 4 to 7).

Investment positioning 

Within this context, we maintain an overall risk-neutral stance relative to the benchmark, reflecting a continued emphasis on risk management. This positioning is designed to preserve optionality and emphasize diversification, allowing portfolios to remain positioned for further upside while identifying relative value opportunities within asset classes. Within this framework, we remain moderately overweight equities relative to fixed income, with an emphasis on defensiveness rather than cyclical acceleration.

• In equities, we maintain an overweight to defensive factors such as quality and low volatility. Defensive factors have historically performed well during slowdown regimes due to more stable cash flow profiles and lower sensitivity to changes in growth dynamics. At the sector level, we favor exposures with defensive characteristics and durable fundamentals, including select areas within information technology, health care, and consumer staples, at the expense of more cyclical areas. From a regional perspective, we continue to maintain a moderate preference for the US relative to developed ex-US markets, and developed relative to emerging markets.
• In fixed income, we maintain a moderate underweight to overall credit risk. This reflects a balance of risks that appears less favorable for spread-based compensation than alternative sources of return within a diversified portfolio. We also maintain exposure to interest rate duration as a risk management tool and a hedge against downside growth risks, with a preference for nominal bonds.
• In currency markets, we maintain an underweight stance on the US dollar. Within developed markets, we remain underweight the Australian dollar, British pound, New Zealand dollar, Swedish krona, and Swiss franc, while maintaining overweight positions in the Canadian dollar, euro, Japanese yen, Norwegian krone, and Singapore dollar. Within emerging markets, we favor higher yielding currencies with relatively attractive valuations, such as the Indian rupee, Indonesian rupiah, Malaysian ringgit, Taiwanese dollar, and Thai baht, funded by underweights in the Chinese renminbi, Colombian peso, Czech koruna, Mexican peso, and South African rand.

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.