Tactical Asset Allocation: February 2022

Key takeaways

Our framework remains in a slowdown regime. Historically, this economic backdrop has led to modest but positive returns across asset classes, with a convergence in performance between growth-sensitive and defensive assets, as compensation for growth risk diminishes.

We maintain a neutral risk stance relative to our benchmark,¹ with an overweight to equites versus fixed income but a tilt toward defensive equity factors (low volatility and quality) and sectors, and an overweight to developed market equities relative to emerging markets. We are overweight interest rate duration and neutral on credit risk, with an exposure to short and intermediate credit maturities. We moved to an underweight US dollar exposure.

Macro update

Global bond markets have experienced a meaningful hawkish repricing of monetary policy expectations over the past two months, with US bond yields rising across maturities by about 20-40 basis points in January 2022 alone. The initial catalyst for this repricing can, arguably, be attributed to news of the Omicron COVID-19 variant in the third week of November, and the resulting magnification of pre-existing inflationary pressures caused by production and distribution bottlenecks. 

While at first the news led to an immediate “growth scare” reaction with falling bond yields and equity markets, the narrative shifted over the following weeks to an “inflation scare,” also acknowledged by the Federal Reserve in its subsequent Federal Open Market Committee (FOMC) meetings. In the January meeting, the FOMC made very clear they are determined to raise rates steadily over the next few quarters, given a very strong labor market and inflation running at 40-year highs across multiple metrics.²

But higher interest rates do not address supply-driven inflationary pressures, and the Fed finds itself dealing with a problem that originated elsewhere, namely supply-side disruptions and, in hindsight, excess fiscal stimulus which was, nonetheless, necessary.  By tightening financial conditions, the Fed is seeking to slow aggregate demand because the supply-side of the economy is not equipped to handle overheating. As a result, the yield curve has continued to flatten aggressively as bond markets price-in a rapid, front-loaded tightening cycle followed by a return to the low growth / low inflation economy that we saw after the Global Financial Crisis. 

While these bond market dynamics have been a prominent part of the market narrative of the past two months, in our opinion they have been in place since the June 15 FOMC meeting, which was the first time that the Federal Reserve explicitly acknowledged the upside risks to inflation and the strength of the labor market, and validated market pricing for rate hikes to commence before the end of 2023. Since then, the market has priced in six rate hikes over the next two years, raising two-year US bond yields by about 102 basis points, from 0.16% to 1.18%. However, 30-year bond yields have declined by about 7 basis points, from 2.18% to 2.11%, resulting in a twist flattening of the yield curve with long-term bonds (10-year +) outperforming short (1-3 year) and intermediate (3-10 year) maturities, posting returns of 1.7%, -1.3% and -2.5%, respectively.³ We see that as a remarkable outcome given a six-hikes repricing of policy expectations.

Footnotes

1. Global 60/40 benchmark (60% MSCI ACWI / 40% Bloomberg Barclays Global Aggregate USD hedged)
   
2. Measures such as US core Personal Consumption Expenditures, core Consumer Price Index and core Producer Price Index currently registering the highest year-on-year rates since the early 1980s.
3. Bond yield changes measured over the period June 15, 2021, to Jan. 31, 2022. Returns calculated using FTSE US government bond total return indices for the 1-3y, 3-10y, and 10y+ sectors, from June 15, 2021, to Jan. 31, 2022.

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