Fair warning, our views blog is longer than normal this month, because there’s more than usual to write about. To start, I’ll summarize the key points about our recommended positioning for a global 60/40 investor:
- Underweight equities about 9%, spread proportionately across regions; this represents a reduction of about 3% from the start of the year, and a removal of our overweight to European equities.
- Neutral duration to benchmark, with exposure primarily in U.S. Treasuries; this is a significant reduction from our long position at the beginning of the year, as rates have declined to levels where we see less potential for further upside.
- Broadly underweight credit, especially high yield (we published a specific blog on this topic in November, and reiterated it in a recent update).
- Neutral U.S. dollar exposure; we cut our U.S. long position in early December; we favor overweighting the Japanese yen for its safe-haven, defensive characteristics in periods of stress.
In our 2016 Outlook we stated that we expected a continuation of the themes that drove markets in the latter half of 2015, with a central view that diverging central bank policy would lead to volatility and risk-on/risk-off behavior for some time to come. In line with this view, we recommended a cautious approach to asset allocation over the near term. While I think our view has been correct thus far, I’ll admit that recent market action has been more like a roller coaster than the seesaw we described, with more sharp drops than ascents.
To give you more insight into our thinking, I want to describe our investment process, and what the different components of it are telling us today. Our approach incorporates three independent perspectives — macro, valuation and risk environment — which we use in combination to judge whether we are well compensated to take risk, and where.
From a macro perspective, our analysis indicates that we are in the “slowdown” regime in most major economies, which is typically a mediocre environment for asset returns. It is also an environment where uncertainty is high, because slowdowns can either re-accelerate into expansion, where risk taking is often well-rewarded, or descend into contraction, which is the worst environment for returns on risky assets. Today, we do not see evidence that either the U.S. or Europe is near contraction. In fact, the sharp drawdown in equities in the past month seems to have outpaced weakness in the macro data.
However, we are concerned that policymakers have less capacity than usual to respond to a downturn, and note that the latest rounds of quantitative easing are yielding diminishing returns. The ECB announced a quantitative easing program a year ago, but the euro has barely moved over that period. Moreover, recent hints of further easing by the ECB and the move to negative interest rates by the Bank of Japan, appear to have had no impact on equity or currency markets.
Valuation is generally not helpful in guiding near-term decisions, but it is very important in thinking about long-term compensation for risk. Today, we think equities offer little better than average compensation for taking risk, even after the recent decline in prices. We also note that momentum, which is a more powerful short-term indicator, is significantly negative across nearly all risky assets.
Which brings us to the third perspective in our toolkit, risk. Near-term risk remains high, as reflected in market volatility. In addition, correlations across risky assets are high, which diminishes the benefits from asset diversification. From a longer term perspective, in the U.S. we continue to see signs that the credit cycle is aging, as corporate leverage has increased, lending conditions have begun to tighten, and underlying economic growth has slowed — all of which give us concern about the potential for further risk emanating from the credit markets.
The combination of diminished response to policy stimulus, negative momentum, high volatility, and an aging corporate credit cycle, lead us to maintain a cautious stance in our near-term recommendations. With that said, what would cause us to become more defensive or more positive in the coming months?
To the downside, a significant decline in our leading economic indicators to the “contraction” regime would push us toward a more defensive stance. As mentioned above, our current analysis is that none of the major developed economies is in contraction, and it would likely take several months of declining data to get there. We are watching our leading indicators closely for signs that consumers and businesses may reduce spending and investment in reaction to the current market stress.
To the upside, we can think of three policy shifts that could alleviate some of the underlying problems in the global economy and lead to a better environment over the near to medium term. In ascending order of importance, they are:
- A move by the Organization of Petroleum Exporting Countries (OPEC) to restrain production to support a higher oil price, which would aid oil producers and help some of the most distressed players in the credit markets.
- A significant devaluation of the yuan by China, which would likely cause short-term turmoil but would be a positive for China’s medium-term prospects.
- A clear signal that the Fed is adopting a more dovish stance. We believe this would be the most powerful “circuit breaker” for the markets.
In summary, our view remains cautious, and we maintain our recommendations to underweight risky assets such as equities and credit to mitigate volatility and downside risk. We are closely monitoring our leading indicators for signs that market stress is impacting the underlying economy, and have identified specific policy actions that could alleviate the key drivers of volatility.
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These views represent the opinions of the Portfolio Managers at OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.