Tactical Asset Allocation: June 2022

We remain overweight risk relative to benchmark, favoring equities over fixed income with an emphasis on emerging markets, cyclicals, and value. We moderately increased credit risk given wider spreads.

Synopsis

• Global equity markets have underperformed since we increased portfolio risk in early April, and leading economic indicators have deteriorated further. However, our market-based sentiment framework shows more stability and still points toward positive growth revisions ahead.
• We are overweight risk relative to benchmark in the Global Tactical Asset Allocation model¹, favoring equities over fixed income with an emphasis on emerging markets, cyclical sectors, value, and small/mid-caps. We have moderately increased credit risk and stay underweight duration.

Macro update

Our leading economic indicators declined sharply for the second consecutive month, reflecting the impact of the war in Ukraine, China’s zero-COVID policy, and higher cost of capital. Unsurprisingly, the decline in economic activity has been most pronounced in China, the Eurozone, and the United Kingdom which, based on our indicators, are now likely to grow below trend over the next few quarters. Despite the resilience in other large economies (US and Japan), the global economic picture has weakened substantially, and our Global LEI is fast declining toward its long-term average, i.e., our proxy for trend growth (Figure 1 and Figure 2).

Despite the resilience in other large economies (US and Japan), the global economic picture has weakened substantially.

Business surveys across manufacturing and service sectors have declined from the peak, but they continue to show resilience and still suggest above-trend business prospects.

Figure 2: Global risk appetite is accelerating, signaling improving growth expectations

GRACI and the global LEI

In terms of economic sectors, consumer confidence surveys across countries have already declined to the recessionary lows experienced in 2008. However, strong labor market conditions today provide a very different backdrop of consumer resilience relative to other recessionary episodes. Business surveys across manufacturing and service sectors have declined from the peak, but they continue to show resilience and still suggest above-trend business prospects. China is the noticeable but not surprising exception. New COVID-related lockdowns since April have caused a meaningful decline in industrial production, construction activity and retail spending, which have led the People’s Bank of China to release a broad range of stimulative tools. However, stimulus efforts may have limited effect if mobility restrictions remain in place.

While equity and fixed income markets have continued to post negative returns since then, our framework still suggests this underperformance is predominantly driven by higher discount yields rather than deteriorating earnings expectations.

At the end of Q1 our macro regime framework moved back into an expansionary regime, led by an improvement in global market sentiment and above average economic activity. While equity and fixed income markets have continued to post negative returns since then, our framework still suggests this underperformance is predominantly driven by higher discount yields rather than deteriorating earnings expectations. The recent outperformance of cyclical market segments such as value equities, small/mid-caps, and emerging markets relative to more defensive segments such as growth, large-cap and US equities provides some support to this hypothesis. In other words, more than an “inflation scare” turning into a “growth scare,” we believe markets have moved from an inflation scare to a de-rating of valuations, particularly in high-duration US growth stocks. Nonetheless, economic risks are rising and a stabilization in credit spreads would be required to prevent further declines in equity markets.

Inflation remains the primary driver of markets. Downside surprises in inflation statistics may represent the most powerful catalyst for a rebound in markets, alleviating risks of excessively restrictive monetary policy. We continue to register accelerating inflation in the near term, but at a somewhat lower pace than the past few months (Figure 3). Interestingly, the rollover in US breakeven inflation expectations seems to suggest a likely peak in actual inflation in the near term².

Downside surprises in inflation statistics may represent the most powerful catalyst for a rebound in markets, alleviating risks of excessively restrictive monetary policy.

Investment positioning

We maintain an overweight risk stance relative to benchmark in the Global Tactical Asset Allocation model1, overweighting equities relative to fixed income, favoring emerging markets over developed markets, and tilting toward cyclical sectors and factors. We moderately increased credit risk³, shifting from short to intermediate credit maturities, and remain underweight duration risk in aggregate while maintaining a flattening yield curve bias. (Figure 4, 5, 6). In particular:

• Within equities we overweight cyclical factors like (small) size, value, and momentum, and favor cyclical sectors such as financials, industrials, materials, and energy at the expense of information technology, communication services, and other defensive sectors (Figure 6). We expect cyclicals to continue outperforming in an environment of rising bond yields and improving risk appetite. From a regional perspective, we overweight emerging markets relative to developed markets as stable risk appetite and attractive valuations tend to benefit the asset class.
• In fixed income we have reduced the overweight in inflation-linked bonds relative to nominal Treasuries given the recent softening in inflation momentum (Figure 3). We maintain an underweight duration stance in aggregate, with a bias toward a flatter curve. We added some credit exposure by increasing spread duration in high yield, looking for some spread compression after the widening of the past few months.
• In currency markets we remain underweight the US dollar, a position driven by expensive valuations and positive economic surprises in the Eurozone and emerging markets relative to consensus expectations. Within developed markets we favor the euro, Japanese yen, Canadian dollar, Singapore dollar, Norwegian kroner, and Swedish krona. In EM we favor high yielders with attractive valuations such as the Indonesian rupiah, Colombian peso, and Brazilian real. We underweight the British pound, Swiss franc, Australian dollar, and Korean won.

Figure 4: Relative tactical asset allocation positioning

Portfolio risk above benchmark, overweight EM and cyclicals. Reduced overweight in TIPS versus nominal bonds.

Figure 5: Tactical factor positioning

Factor tilts within the expansion regime are toward size, value and momentum

Figure 6: Tactical sector positioning

In an expansionary regime, sector tilts favor cyclicals relative to defensives.

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20220614-2241881-JP

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