Tactical Asset Allocation: November 2022

Underweight risk relative to benchmark, favoring fixed income and defensive equity factors.

Synopsis

• Our macro framework remains in a contraction regime. While Q3 earnings have outperformed expectations, forward estimates continue to decline, suggesting weaker growth ahead.
• Underweight risk relative to benchmark in the Global Tactical Asset Allocation model¹, favoring fixed income over equities, underweighting credit risk² and overweighting duration. In equities, favor defensive equity factors and sectors, and underweight emerging markets. We move back to neutral on the US dollar.

Macro update

Leading economic indicators suggest global growth to remain below trend. Economic activity weakened in the Eurozone, UK, Japan, and emerging markets, while the US economy has stabilized. Surveys of consumer sentiment remain around all-time lows but stable in both the United States, Eurozone, and United Kingdom. Business surveys, manufacturing activity and the construction sector continue to decline towards their long-term trend, while monetary conditions continue to tighten via higher policy rates, flattening yield curves and falling money supply growth. Risk sentiment improved. Credit spreads compressed by about 100 bps in lower quality sectors and global equity markets, boosted by favorable Q3 corporate results³, have risen approximately 6% in US dollar terms in October, equivalent to the top decile of monthly returns of the past 25 years. However, this improvement in risk appetite was not sufficient to flag an inflection point in the market cycle, and our framework remains in a contraction regime (Figure 1 and Figure 2).

Leading economic indicators suggest global growth to remain below trend. Economic activity weakened in the Eurozone, UK, Japan, and emerging markets, while the US economy has stabilized.

Improvement in risk appetite was not sufficient to flag an inflection point in the market cycle, and our framework remains in a contraction regime.

Markets have responded favorably to positive surprises, and an earnings season that certainly dispels the threat of an imminent recession.

The S&P500 is on track to post a beat this earnings season with headline EPS growth at approximately 3.8% year-over-year growth vs. initial consensus around 2.6%. Further, sales are holding up better than earnings, on track to increase by 9.7% year-over year in Q3, above consensus by 1%, and rising also on an ex-energy basis at around 6.7%. In the rest of the world, earnings season has been very strong in Japan with overall EPS growth at about 22% year-over-year, and top-line growth at 17% year-over-year. Results have been somewhat softer in Europe, with EPS growth around 5% year-over-year below expectations by about 1%, but revenue growth surprising to the upside at 20% year-over-year. Markets have responded favorably to positive surprises, and an earnings season that certainly dispels the threat of an imminent recession. While this is certainly good news, a focus on forwardlooking estimates paints a softer picture for the corporate sector, suggesting caution still required before calling for a definite inflection point in the market cycle.

Earnings revision continue to decline both in the US and rest of the world. Since the start of the earnings season, forecasts for S&P 500 EPS growth for all quarters until Q4 2023 have been reduced by 100-150bps per quarter. Margins are under pressure, with consensus estimates seeing a decline in net income margins by about 20-30bps per quarter over the next five quarters. The evolution of these estimates is largely in-line with our leading economic and market sentiment indicators, suggesting the economy is on a soft-landing path at this stage (Figure 3). Recession risk remains elevated, given the low level of growth and headwinds from cumulative policy tightening, but the resilience in the labor market continues to support overall economic activity. On the inflation front, business surveys across the globe indicate peaking prices pressures, in line with our read on three-month inflation momentum, but this deceleration is yet to be reflected in aggregate headline and core CPI statistics which continue to increase across the developed world (Figure 4).

The evolution of these estimates is largely in-line with our leading economic and market sentiment indicators, suggesting the economy is on a soft-landing path at this stage.

Business surveys across the globe indicate peaking prices pressures, in line with our read on three-month inflation momentum, but this deceleration is yet to be reflected in aggregate headline and core CPI statistics.

Investment positioning

We expect these defensive characteristics to outperform in an environment of below-trend and slowing growth, declining inflation, and peaking bond yields.

We favor investment grade credit and duration in long-dated government bonds, expecting more flattening in the yield curve.

We have reduced the US dollar exposure back to neutral as global growth is performing in-line with consensus and yield differentials between the US and the rest of the world have stabilized.

We maintain an underweight risk stance relative to benchmark, expressing a defensive bias across most levers in the portfolio, but reduced the US dollar exposure back to neutral vs. benchmark. We remain underweight equity in favor of fixed income, which now offers attractive 6% yields in investment grade or 8-9% yields in risky credits. Within fixed income we remain underweight credit risk⁴ and overweight duration relative to benchmark (Figure 5, 6, 7). In particular:

• Within equities we underweight value, small and mid-cap equities, favoring defensive factors like quality, low volatility, and momentum, resulting in defensive sector exposures with higher duration characteristics and lower operating leverage such as information technology, communication services health care and consumer staples, at the expense of financials, industrials, and materials. We expect these defensive characteristics to outperform in an environment of below-trend and slowing growth, declining inflation, and peaking bond yields. From a regional perspective, we maintain a moderate underweight in emerging markets relative to developed markets, as declining growth and tightening financial conditions provide headwinds to emerging markets. We remain neutral between US and developed ex-US equities.
• In fixed income we are underweight risky credit as a contractionary regime has historically led to underperformance in high yield, bank loans and emerging markets relative to higher quality debt with similar duration. While high yield spreads have tightened by about 100bps over the past month, we remain cautious given the macro backdrop, and wait for an inflection in the cycle before increasing exposure. We favor investment grade credit and duration in long-dated government bonds, expecting more flattening in the yield curve. We expect further compression in breakeven inflation expectations given declining price pressures, overweighting nominal treasuries relative to inflation-linked bonds.

• In currency markets we have reduced the US dollar exposure back to neutral as global growth is performing in-line with consensus and yield differentials between the US and the rest of the world have stabilized over the past few months. 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, while we underweight the Korean won, Taiwan dollar and Chinese renminbi.

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20221109-2583656-JP

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