Muddling through

  • Written by 
  • 17/12/2015

As the global economy continues to muddle through the current soft patch, we share our thoughts behind our recommended tactical positioning. We continue to believe that investors remain best served by leaning portfolios towards Developed Markets Equities, and the US and Continental Europe in particular.

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We maintain a Strategic Asset Allocation for five risk profiles, based on our outlook for each of the asset classes. Our Tactical Allocation Committee (TAC), comprised of our senior investment strategists and portfolio managers, regularly assesses the need for tactical adjustments to those allocations, based on our shorter-term (three to six month) outlook. Here, we share our latest thinking on our key tactical tilts.

Developed Markets Equities: Increased to Strong Overweight from Overweight (20 January 2016)

The Tactical Allocation Committee took advantage of the dramatic plunge in investor risk appetite seen at the start of the year to further add to Developed Markets Equities within portfolios, taking our recommended position up to strong Overweight. We continue to believe that while the next US and global economic recession is of course inevitable, it is not imminent.

“Investors should be prepared for further volatility as risk appetite remains fragile”

Seismic past moves in oil prices and the US dollar have warped our view of the world economy, however we maintain that the world economy and its corporate sector are capable of continuing to muddle through for the moment. As sentiment continues to normalise amidst this ongoing economic growth, we suspect that further upside awaits for Developed Markets Equities.

This view that the effects of moves in oil prices and the dollar are indeed transitory is particularly important for our view on US equities, where much commentary is suggesting that the end of the profit cycle is upon us. We see this as a mistake and remind ourselves that most of the time economic growth leads corporate profitability, not the other way around. Profitability is also important to our call on Continental European equities, where profits have further to recover in our opinion as domestically focused businesses in particular are finally freed from the rolling existential crisis that has dogged the region for the last few years.

Cash & Short-Maturity Bonds: Reduced to Neutral from Overweight (20 January 2016)

Given the recent severe market disturbances, cash continues to play a pivotal portfolio insulation role. While the fixed income universe remains unattractive at current extreme valuations, cash offers a source of funds to invest into other asset classes when appropriate opportunities arise. Evidence of some returning inflation in the US needs to be watched very carefully obviously.

“With oil prices still depressed, pressure on energy credits is likely to remain”

Developed Government Bonds: Neutral

With nominal yields on large chunks of the government bond universe negative or close to it, investors will likely have to work hard to make real returns from these levels over the next several years. Our view remains that such valuations underestimate the underlying inflationary pressures within the US economy in particular, something that incoming inflation data pay some testament to. While the level of (returns insensitive) central bank ownership suggests that the bond market may lag a pick-up in inflation, our continuing small strategic and tactical allocation to the area suggests that higher real returns lie elsewhere.

High Yield & Emerging Markets Bonds: Underweight

Junk credit is of tactical interest currently with yields in the ex-energy space now consistent with a rise in defaults that we regard as unlikely in the context of our view of the immediate prospects for the US economy. With oil prices still depressed, pressure on energy credits is likely to remain. Emerging Markets Bonds are expensive and remain vulnerable to a reversal of inflows during the slow process of monetary normalisation.

Emerging Markets Equities: Increased to Neutral from Underweight (20 January 2016)

The TAC moved their recommended position in Emerging Markets Equities up to Neutral earlier this year. The case for further meaningful downside is now harder to make in the context of the underperformance already suffered by the space over the last several years. Much bad news is already factored into our view, while the potential for a further dramatic ascent of the US dollar, helpful in stoking fears of a repeat of the late 1990s, is also somewhat diminished given a less extreme valuation.

Investment Grade Bonds: Underweight

The spread of investment grade credit over government bond yields remains within its historical range. However, this leaves nominal yields in high quality corporate credit low in absolute terms and may make the job of those trying to make positive real returns difficult.

Commodities: Underweight

The TAC continues to recommend an Underweight position in Commodities. China’s slowdown is unhelpful of course, and stockpiles remain a headwind for further spot price recovery in many areas, with oil and copper two notable examples.