Tactical Asset Allocation – Monthly Update

Our framework continues to suggest the global economy is in a slowdown regime, with growth above its long-term trend and decelerating. Risk sentiment is being pulled in opposing directions: renewed geopolitical escalation in the Middle East is pushing energy prices higher, while resilient economic growth and robust corporate earnings are continuing to provide support. These competing headwinds and tailwinds, coupled with persistent inflation and new uncertainty around the Federal Reserve’s (Fed’s) path, reinforce our position to remain diversified and hedge growth risks while preserving risk-on optionality. As a result, 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 meets rising policy and geopolitical uncertainty

Positive earnings momentum continues, supported by another strong quarter of results. The blended earnings growth rate for the S&P 500 in the second quarter is nearly 38%, which, if sustained, would represent the highest year-over-year earnings growth rate since Q3 2021. Additionally, despite earnings strength being relatively concentrated within the energy, communication services, and information technology sectors, excluding notable Magnificent 7 outperformers such as Alphabet, the S&P 500 would still be on track for a year-over-year blended earnings growth rate of 26%. This would represent a seventh straight quarter of double-digit earnings growth, highlighting the corporate sector’s broad resilience.

Geopolitical risks have resurfaced, as the previous ceasefire between the US and Iran ended and hostilities escalated. Tanker traffic through the Strait of Hormuz effectively stalled, causing energy prices to move meaningfully higher, and fueling renewed inflation concerns and cross-asset volatility. 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. While the full growth impact of the now six-month conflict has yet to appear in our economic indicators, inflation risks remain elevated, and risk assets remain vulnerable to related volatility.

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. These demand dynamics, combined with a tight labor market, have offset higher prices caused by the US-Iran conflict, despite weakening consumer sentiment. Developed non-US economies also remain above trend, with similarities to the US, including a recent rebound in consumer sentiment as energy levels, despite remaining elevated, have not returned to the highs seen a few months ago. 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 subdued, despite higher energy prices over the month (Figure 3). While inflation remains elevated and ongoing hostilities in the Middle East have pushed energy prices higher, recent energy price volatility remains below levels experienced earlier this year. However, elevated energy prices relative to pre-conflict levels, combined with years of inflation running above target, leave the Fed in a position of combatting higher price pressures — a challenge that new Chairman Kevin Warsh has reiterated numerous times. However, financial markets are beginning to question the commitment and ability of the Federal Open Market Committee (FOMC) to successfully bring inflation back to target. That is reflected in the recent steepening of the yield curve and increase in term premium. This subsequent rise in higher yields poses a headwind to risk assets, placing pressure on equity market valuations as higher real interest rates complicate the risk-reward tradeoff for global investors.

In summary, the current mix of above-trend economic growth and a modestly decelerating trend in risk sentiment supports 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 a convergence in performance 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. Additionally, the low volatility factor has demonstrated desirable hedging qualities during momentum unwinds, evident most recently in semiconductor-related companies. 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 such as energy and financials. 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 to 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.