What our House View means for asset allocation and portfolio construction.
- The economic cycle is not over, and neither is the positive environment for risk assets
- However, a mid-cycle environment warrants defensive asset allocation adjustments
- China’s property-led slowdown and slew of enforcement measures is a headwind for 'reflation' trades, including G10 rates and EM currencies, but inflation remains a key theme
- Upside risks to growth and inflation warrant a negative view on risk free assets as central banks prepare for tightening
Going into the final quarter of the year, our asset allocation remains broadly pro-risk oriented. Contrary to many market commentators, we regard neither the year-to-date rally in global equity markets nor the fact that peak economic growth is behind us as a reason to significantly lighten up on our overweight equity positions and cyclical relative value trades.
Maintaining a pro-risk allocation at this point in the economic cycle
That said, transitioning into a mid-cycle environment comes hand-in-hand with lower outright equity returns than an early-cycle environment, and regional and sector leadership typically becomes more mixed; hence we add somewhat more defensively oriented trades. Further, we reduce our short duration exposure in acknowledgement that being underweight government bonds beyond shorter time horizons is betting against risk-premia embedded in this asset class and that also here, moving out of an early-cycle macro environment makes being short duration less asymmetric than before.
Drawing equity market implications from our economic outlook, we note two findings: first, growth is now firmly decelerating on a trend basis and second, our outlook is no longer significantly more positive relative to other economic forecasters.
In addressing the first finding, we look at global equity market returns through the lens of a four-quadrant economic growth framework, differentiating between accelerating and decelerating growth, above and below trend. Figure 1 shows the evolution of these quadrants alongside the MSCI World Index. The amber shaded parts of the time series reflect the growth quadrant we are currently in through history. Whilst by far not the most attractive quadrant in terms of risk-reward, we judge the current early phase of this environment with a contextual three-month mean return of approximately two to three per cent as sufficiently attractive to remain tactically invested in equities. Notwithstanding a relatively positive fundamental outlook, equity markets can draw down at any time and a correction of around ten per cent is possible (Figure 2).
Figure 1. Evolution of economic growth quadrants along MSCI World
Figure 2. MSCI World drawdowns across economic growth quadrants
Knowing which growth quadrant one is in and following a simple investment strategy, remaining long the equity market in all quadrants bar the one during which growth is sub-trend and decelerating, has led to smooth and market-beating returns (Figure 3).
Figure 3. Investment strategy payouts
In contrast, following an investment strategy that incorporates 'consensus' thinking on growth, whereby we incorporate revisions and surprises to growth, respectively, leads to less positive and more erratic strategy returns than using actual real-time growth.
Based on this read-through from economic growth to equity markets, so long as our growth outlook remains above trend, being invested should pay off.
We supplement a fundamentally driven view on equities with quantitative risk-taking signals.
These are aimed at capturing behavioural biases which exist among investors and identifying market regimes. Both frameworks, fundamental and quantitative, arrive at the same message of signalling a positive environment for risky assets; while still supportive, technical indicators have weakened somewhat as well.
The main risk to our view comes from higher government bond yields that are entirely driven by higher real rates, for example a swift re-pricing of monetary policy combined with disinflation. However, so long as real rates remain negative (Figure 4), the economic cycle remains favourable, and our quantitative signals indicate risk-on, we anticipate being buyers of potential equity market drawdowns.
Figure 4. Policy rate expectations
Within our equity allocation, we have added an overweight in US healthcare versus the broader market. This trade is testament to our acknowledgement of investors’ greater appreciation of higher quality and more defensive sectors during mid-cycle transitions. We further regard the healthcare sector as one of the cheaper sectors of that nature and one that is positively geared towards rising real rates. It is further a sector with positive longer-term earnings growth potential given higher health care spent in light of changing demographics and signs of a favourable innovation cycle.
We have closed our preference for US versus EM equities following strong outperformance by the former, driven by the Chinese regulation of the tech sector and broader common prosperity agenda, which involves redistribution policies away from capital. From here, and in light of adjusted relative valuations and premia built back into EM FX, a narrowing gap in the US-EM growth differential and potential for Chinese monetary and fiscal stimulus, we take a neutral view on the pair – despite the very real possibility of shareholder policies becoming even less friendly.
After a formidable rebound in H2 2020, 2021 has been difficult for local currency emerging markets. Perhaps surprisingly, the carry from the higher yields mentioned above has meant that the JPMorgan ELMI+ FX index has slightly outperformed G10 currencies YTD. The GBI-EM local bond index has taken large capital losses on rising yields, as EM central banks have hiked rates – in some cases aggressively and in almost all cases ahead of expectations (Figure 5), causing bond curves to bear steepen. We are not underweight as the commodity cycle and global growth generally buoy the asset class, but from here on EM growth will increase imports, while weak portfolio flows and unstable politics (particularly in Latin America) makes risk/reward uncompelling. Above all, the support from China’s stimulus that helped emerging markets in past cycles is not expected to return for the foreseeable future (Figure 6).
Figure 5. Emerging Market yields have risen
Figure 6. Emerging Market growth and FX is sensitive to China
Since 2017, China has de-emphasized, but not abandoned, GDP growth as a target, but throughout 2018-20 policymakers had to balance deleveraging efforts against Trump’s ill-advised trade war and the global crisis wrought by COVID. Now that those struggles have been successfully navigated – at the cost of larger inequality, pollution, and even higher leverage and financial vulnerabilities – a multi-pronged policy-induced slowdown has emerged (see House View Themes for more details). Our downgrade to China’s growth trajectory is one reason for a slightly lower US bond underweight; in contrast policy easing in China will not be massive, but supports an overweight to Chinese government bonds.
The Federal Reserve is expected to begin tapering QE purchases in late 2021, with the programme ending (for now) in mid-2022. Conditions for a Fed Funds lift-off, including full employment and PCE inflation sustainably above two per cent are likely to be met around the end of 2022; while some hikes are priced in (Figure 5), the path of rates is well below what the median FOMC member expects as a likely scenario, with a terminal rate of just two per cent, far below the 2.5-2.75 per cent longer-term projection.
Elsewhere, in Canada and across Europe, monetary authorities have already begun to decrease the pace of asset purchases, with a few already raising interest rates, albeit slowly and to still very low levels. With inflation pressures building, markets need to balance the probability of central banks’ eventually needing to tighten above neutral against the medium-term probability of another recession – and a return to zero rates and more QE – in the years ahead.
The flattening of G4 yield curves in Q2-Q3 has been one of the biggest surprises of the year for us, and is an overreaction to the delayed reopening caused by the Delta variant as well as the impact of QE and global demand for safe assets. Our judgement is that growth and inflation risks will overcome a decelerating China, and that interest rates will rise above what is implied by the yield curve. Hence, we maintain a negative view on risk free assets such as US Treasuries and UK Gilts, and expect steeper curves in coming quarters to more than offset carry in global government bond indices.
As for credit, both high yield and investment grade corporate spreads are slightly wider (relative to the past quarter), but the changes have been marginal and we continue to avoid the asset classes given spreads remain near their all-time tights. We expect this means giving up some carry as defaults and downgrades remain low, but the prospective returns are asymmetric on a medium-term basis and unfavourable relative to equities.