As the fourth quarter of the year begins, the market environment remains somewhat calm.

Central Banks worldwide remain as engaged with the markets as they have been since the financial crisis. Monetary policy is fairly loose. And global economic growth is relatively tepid with nary a sign of inflation, despite central banks’ best efforts to turbo-charge both.

Developed markets (DM) continue to putter along, with modest growth in the United States and Europe, in my view. But there are plenty of people who would question that assessment. I still firmly believe that this is going to be the longest business cycle anyone of us has ever experienced.

Unlike the last few years during this time of the year, what is less debatable is that emerging market (EM) growth is actually stabilizing, with the potential for an upside kicker. The driver of EM growth, of course, is debt-driven cyclical stabilization in China, which is providing support to the commodity complex globally. It’s still unclear whether this trend is sustainable or not.

There are potential green shoots in the oil markets, with talk of an accord among members of the Organization of the Petroleum Exporting Countries (OPEC). But again, whether any of the potential price and stabilization benefits of that outcome are sustainable is very much an open question.

The Bank of Japan (BOJ), which has been the master experimenter in monetary policy, seems to be taking a different route. Instead of focusing on base money expansion through asset purchases and lowering policy rates, it is getting bolder by targeting the entire yield curve. We don’t yet know how successful the BOJ would be in supporting economic growth and inflation. What is not debatable, in my view, is the fact that the central bank of Japan will end up stabilizing interest rates worldwide. Global interest rate volatility is heading lower from its already low level. That downward trend, in turn, should be very supportive of asset prices and lower volatility.

From an asset-allocation perspective, as you would expect in this sort of an environment, risky assets are not cheap by any measure anywhere, and in some (or most) markets you have to stoop down to compare every asset class—be it equities, credit or EM interest rates—with safe asset classes to find them appetizing. This exercise may be less than satisfying, but at the end of the day, asset allocation is a relative game, and the comparison I’ve just described remains the right framework, in my view.

Finally, with interest rate volatility drifting lower, currency volatility remains relative low.

Against this economic and market background, not a whole lot has changed in our views on asset allocation.

1. Equities

We still believe global equities remain the asset class of choice—especially EM equities, which have the potential to surprise on the upside. In DM, I favor U.S. equities. However, within the United States, it is still very much all about growth stocks and bond proxies. In a growth-short world, growth stocks are still likely to deliver. There is nothing sexy about bond proxies, but in a market where 10-Year U.S. Treasuries are yielding 1.5%, you need stability and income far more than sexiness.

2. Credit

Large-scale asset purchases by the European Central Bank (ECB) and demand for income in a low interest rate environment are the two pillars supporting the global credit markets. As an asset class, credit should provide modest returns. The key word here is “modest,” as the snapback since the first quarter of this year has tightened credit spreads back to near cycle lows. Within credit, our asset of choice remains senior floating rate loans; their risk-adjusted returns are likely to be higher than those of high-yield bonds and EM debt. Yet, for higher absolute returns, EM debt may still outperform owing to its longer duration and stable spreads.

One surprise entrant in our “attractive column” is floating-rate, money-market instruments (both taxable and tax free).

In the interest rate markets, we favor EM local debt. We believe that stable or strengthening currencies (the product of a relatively stable or weakening dollar), high yield and a structural downward trend in interest rates make EM local debt our asset class of choice, despite its already very strong performance.

2. Commodities

The strength of the cyclical rebound in EM should keep commodities relatively stable, with the potential for an upside surprise if the OPEC accord has a positive impact on prices. In the longer run, commodities remain as vulnerable as ever because of structural issues in EM. Therefore, we believe commodities remain a cyclical trade rather than a more permanent form of portfolio protection against runaway inflation.

Beware of market risk

Having said all of this, we maintain a modest outlook for returns, primarily because valuations are high across the board. Adding insult to injury, market risks are elevated and serve as a reminder to avoid being overexposed.

  • The risk of a rate hike: The Federal Reserve is still looking to hike interest rates. I don’t believe it eventually will, as the economy is slowing, but it could. In the aftermath of such a hike, the dollar could break higher and cause virtually all risky assets to decline.
  • Political risk: While the markets have now started to discount a status-quo outcome in the U.S. elections, the race remains too close to be ignored.
  • Financial sector risk: I continue to believe that the likelihood of Deutsche Bank creating a mini financial scare remains quite low, given its improved liquidity position and the likelihood of a lower fine it would need to pay U.S. authorities for allegedly improper dealings in residential mortgage-backed securities. Nevertheless, what Brexit taught me is that in today’s world, bizarre and unexpected things do happen, and downside prospects need to be incorporated in one’s risk calculations, no matter how unlikely the scenario.
  • Market risk: Finally, we are well into a mature market cycle, and the rebound in global economic growth is now being led by EM rather than a more historically predictable economy like the United States. This fact places the world economy in an inherently riskier position. Further, many investors have garnered significant returns since the first quarter’s drawdown—and since the market cycle began in 2009. Therefore, any bout of volatility, however unlikely, will tempt them to exit the market for profit-taking. In this kind of environment, we believe the risk of drawdowns to the market and to the global economy remains elevated.

So, the market appears to be in “risk-on” mode for now. But we should remain vigilant.

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