The Multi Asset Teams Views on Asset Allocation (Q4 2018)
Global growth has peaked, and the deceleration in economic activity, while not severe, is broad- based. Our leading indicators suggest the United States is entering a slowdown regime, joining the deceleration experienced by Europe and emerging markets (EM). Market sentiment remains weak, particularly in non-U.S. markets.

Over the past month, we have not made any significant changes to the portfolio. Our overall stance remains slightly defensive, with a modest underweight to global equities and overweight to duration. We maintain a significant exposure to alternative assets such as event-linked bonds and master limited partnerships (MLPs), at the expense of investment-grade debt and core U.S. equities. We closed our position in EM local debt in mid-August.

Following are our views on major asset classes and our positioning in them.

U.S. Equities

We hold a modest underweight to U.S. equities as part of our underweight to global equities. We are overweight small caps and mid caps versus large caps, overweight quality, and underweight value.

  • Our leading indicators suggest the U.S. economy is likely to slow over the next few quarters, after experiencing strong growth acceleration in the first half of the year. Monetary conditions continue to tighten, albeit at a gradual pace, while activity in the construction and industrial sector is peaking. We expect growth to decelerate, but remain solidly above trend.
  • We expect small caps and mid caps to outperform large caps, benefiting from domestic fiscal expansion, as long as credit markets remain stable, while being more insulated from weakening growth outside the U.S.

European Equities

We hold a modest underweight to European equities as part of our underweight to global equities.

  • European growth continues to decelerate, and this slowdown is widespread across all major Eurozone economies. With over 30% of revenue exposure to EM, Europe is likely to see a marginal drag from external demand given recent growth disappointments in Asia and the negative impact from trade-policy uncertainty.
  • Last quarter we flagged Italy as one of the key risks to watch. So far, the Italian government has delivered more constructive rhetoric on upcoming budget proposals than we initially expected. We see risks for a new budget proposal around 2%-2.3% of GDP that, while below the Maastricht Treaty limit of 3% of GDP, is likely bring into question debt sustainability in the face of slowing GDP growth and the end of quantitative easing by the European Central Bank.

EM Equities

We hold a modest underweight to EM equities as part of our underweight to global equities.

  • Our leading indicators suggest EM growth should continue to decelerate, with risks of falling below trend, therefore registering a “contraction” in our macro regime framework. Manufacturing surveys indicate an inventory cycle that has not fully adjusted yet, as orders-to-inventories ratios are still falling. China’s renewed fiscal policy efforts are partially a reaction to this macro picture and aimed at stabilizing downside risks.
  • Tensions in global trade policy continue to rise, as exemplified by the threat of additional tariffs on as much as $200 billion in U.S. imports from China, bringing the total to nearly 60% of all Chinese imports into the United States. Together with tightening financial conditions, global trade uncertainty is weighing negatively on EM sentiment. Our global risk appetite framework is signaling very weak market sentiment, down to levels last seen in mid-2015, warranting a defensive stance on EM equities despite good valuations.

U.S. Credit

We are underweight credit. We prefer sourcing income via uncorrelated alternatives such as event-linked bonds.

  • Lending standards remain very generous and credit markets are well-behaved, as indicated by the outperformance of riskier sectors such as high-yield and loans versus investment-grade debt. However, at these levels of credit spreads, we continue to see limited upside and prefer sourcing income from uncorrelated alternatives (event-linked bonds), and reducing the portfolio’s aggregate exposure to traditional macro risks embedded in credit spreads such as growth, risk appetite, and tightening financial conditions.

EM Fixed Income

We closed our exposure to EM local debt.

  • We are waiting for a few catalysts, such as a re-acceleration in EM growth, a dovish turn in U.S. Federal Reserve (Fed) policy or a meaningful resolution in U.S.-China trade policy, before returning to the asset class.

Government Bonds

We are overweight duration via U.S. and developed markets sovereign fixed income, with a curve-flattening bias.

  • Slowing growth, fragile risk appetite, and stable inflation continue to justify our overweight duration stance. While we believe the Fed will continue to tighten once per quarter this year, interest rates seem fairly priced at this stage, which should leave the long-end of the curve less exposed to Fed rate hikes.

Foreign Currencies and the U.S. Dollar

We are partially hedged versus our benchmark, with underweight positions in the Euro and a few EM currencies. We continue to hold an overweight to the Japanese yen.

  • Ongoing weakness outside the United States argues for a modest overweight to the U.S. dollar, as domestic equities remain more attractive than foreign equity markets, encouraging equity capital to stay in the United States. We are waiting for positive economic surprises in foreign markets to re-establish a bearish position in the greenback.

Alternatives

We are overweight alternatives via event-linked bonds and MLPs.

  • We remain overweight event-linked bonds. This market continues to offer value, especially considering how tight traditional credit spreads are trading. Although event-linked bonds have performed well since we added to the position Q2 this year, modest spread widening around Hurricane Florence (which we do not see as a major loss event for the market) leads us to maintain our position, at least for now.
  • As discussed in our July 2018 update, we are overweight MLPs at the expense of large-cap U.S. equities.

Main Risks to Our Views

Dovish shift in Fed rhetoric. While we expect the Fed to continue hiking rates through at least mid-2019, a dovish shift in communication is likely to provide substantial relief to risky assets, particularly in EM, while weakening the dollar. A Fed signal that monetary policy has reached a neutral stance would indicate the approaching end of the tightening cycle, extending the current market cycle even further.