Overall, the members of the asset allocation committee expressed caution regarding the investment outlook. Familiar concerns - including uncertainty associated with trade conflict, Italian politics and US mid-term elections - were cited. But so too was a concern that after a run of strong US equity market outperformance, markets were likely to stall or even dip unless investors find reason to look elsewhere for fresh leadership. Yet against the backdrop of peaking US growth and the absence of a compelling improvement in growth or earnings elsewhere, the committee is sceptical that a full-fledged rotation, for example into value stocks, is likely. Moreover, concerns were also expressed about a possible acceleration of inflation, which would undermine the case for equities, bonds and credit.
The discussion preceded this month’s key US economic data, which exceeded consensus expectations. Yet that outcome has proven to be more negative for global bond markets than supportive of global equities. Indeed, higher short- and long-term interest rates are beginning to pose a relative valuation challenge to equities, as US interest rates move above dividend yields. Rising oil prices are also drawing attention, with the risk that at some point they could sap demand in oil importing countries.
Still, not all indicators are negative. Our short-term tactical asset allocation models shifted one month ago into ‘risk-seeking’ territory and our longer-term ‘regime shift’ indicator is edging in the same direction. Growth surprises outside the US appear to have bottomed and are poised to move higher. The third quarter US earnings season is slated to deliver 20% year-on-year earnings growth, with cash flow boosted by this year’s tax cuts. US real household income growth and personal savings rates are supportive of final demand, as is corporate capital spending in most advanced economies. Even evidence that US interest rate sensitive sectors have peaked probably has more to do with capacity constraints (housing) or the end of the replacement cycle (autos), than with Federal Reserve monetary policy restraint.
Yet markets are clearly struggling at the beginning of Q4 2018. Bullish sentiment has faded, particularly as this year’s strongest performers, such as information technology, slip back. Investors are not willing to engage in value as a style, and remain hesitant about Europe, financials or emerging markets, in the latter case for both equities as well as local currency debt.
Notably, even China’s announcement of a significant easing of credit policy was met with scepticism. Investors apparently see the step as confirmation that China will not seek a trade compromise with the Trump administration to prevent tariff escalation.
Finally, the recent surge in global long-term interest rates is causing concern. On the surface, that is a bit odd, since much of the rise has been in real rates rather than inflation expectations, which remain at non-threatening levels. In part, higher yields reflect technical factors related to ebbing US corporate pension demand for duration fixed income. But, as mentioned, rising rates along the curve are challenging the relative value case for equities and are causing investors to pause.
Reflecting these cross currents, the consensus view of the asset allocation committee is to adhere to a relatively cautious stance. Partly, that is via portfolio construction, with an emphasis on low correlation components, such as short duration credit, insurance-linked bonds, mortgage-backed securities and carry at the front end of the US Treasury curve. Most alternative strategies have failed to deliver adequate returns, though select target return approaches, which employ diversified relative value positions, merit inclusion.
Ahead of the Q3 earnings season we prefer to maintain modest overweight exposure to global equities, with a preference for higher quality stocks, accompanied by some shift toward value, principally via modest allocations to Japan and emerging markets. In our target return strategies we have also made small shifts to increase relative value positions in emerging markets, European financials and local currency emerging debt (funded out of commodity currencies).