The Multi-Asset Teams Views on Asset Allocation (Q1 2019)
Global growth continues to slow, led by the deceleration of economic activity in Europe and most recently the U.S. However, we see early signs of stabilization in emerging markets (EM), which is tentatively confirmed by the recent market price action.

Emerging market equities have outperformed developed markets during the global equity sell-off of Q4 2018. Similarly, our global risk appetite framework suggests improving market sentiment for the first time since April. As a result, we have increased risk in our portfolio after being underweight global equities for the past six months, bringing our total equity exposure back to neutral. In addition, we have moved to overweight in emerging market equities versus developed markets.

U.S. Equities

We hold a modest overweight position in U.S. equities, mainly via master limited partnerships (MLPs). Our factor exposures are currently tilted to value, small caps, and momentum.

  • Our leading economic indicators suggest the U.S. economy has entered a slowdown phase of the business cycle, where growth remains above trend, but at a decelerating rate. This deceleration is led by slower housing activity and tighter financial conditions, while consumer and business sentiment remains strong.
  • Within U.S. equities, we maintain an overweight exposure to MLPs given attractive valuations, ongoing incentive distribution rights (IDRs) elimination, and a constructive outlook for volume growth in energy production.

European Equities

We remain underweight European equities, as a relative value play versus overweight exposure in U.S. and emerging market equities.

  • Our macro regime framework suggests that European growth is likely to decelerate further into the first half of 2019. After a meaningful deceleration in export growth in 2018, leading indicators of manufacturing activity suggest further downside risks. Italy remains the weakest link in the region and on the verge of a new recession. GDP growth dipped into negative territory in Q3 2018 for the first time in 4 years. While political uncertainty is receding, sovereign spreads remain elevated, and leading indicators suggest downside risks.   
  • The European Central Bank confirmed the end of its quantitative easing (QE) program which removes, on the margin, incremental monetary support from balance sheet expansion. While monetary conditions remain accommodative, credit growth in the private sector runs at a modest 3% per year, in line with nominal GDP growth, suggesting a lack of excess liquidity and limited upside in domestic demand growth.

Emerging Market Equities

We have re-established an overweight position in EM equities as a relative value play against international equities.

  • After a pronounced deceleration in 2018, our leading economic indicators suggest growth in emerging markets may stabilize soon, and move back into recovery by mid-2019. A new round of Chinese stimulus, recent improvements in the U.S.-China trade dispute, and a stabilization in U.S. long-term interest rates are likely catalysts of improving business confidence over the next few months.
  • Similarly, our global risk appetite framework is showing clear signs of improving market sentiment, particularly in EM equities, which, despite their higher risk profile, have outperformed developed markets during the global equity sell-off of Q4 2018. Historically, these cyclical turns in risk appetite have preceded a cyclical turn in economic activity by about 2-3 months. As a result, we have re-established an overweight position in EM equities at the expense of international equities.

U.S. Credit

We continue to have no credit allocation in our portfolio, which represents a meaningful tilt versus our benchmark. We see limited upside this late in the cycle, and an investment case limited to income generation. Instead, we prefer sourcing income from uncorrelated alternatives such as event-linked bonds.

Developed and Emerging Market Fixed Income

We are neutral on duration and EM local debt.

  • As in the past, we are not worried about a sustained rise in long-term interest rates given the lack of inflationary pressures worldwide. We expect U.S. bond yields to remain in a narrow range below 3%, and foreign bond yields in a similar holding pattern around their current levels. We expect the U.S. yield curve to flatten, and a likely inversion of the 3-month to 10-year slope by mid-2019.
  • EM local debt continues to offer attractive real interest rates over developed markets, a feature that, however, did not shield the asset class from underperforming in 2018. We remain on the sidelines for now, while favoring exposure to EM equities. We wait for more evidence of a peak in the U.S. dollar before turning more bullish on EM fixed income more broadly.  

Foreign Currencies and the U.S. dollar

We hold a moderate overweight to foreign currencies, mainly via the Japanese yen.

We believe that U.S. dollar strength in 2018 was a pause in the long-term bear market for the greenback, which started around mid-2016. Our valuation framework suggests the U.S. dollar is expensive. Larger fiscal and trade deficits are likely to put downward pressure on the dollar once the cyclical backdrop outside the U.S. improves again, complicating the ability of the U.S. to attract sufficient foreign capital inflows.