Our Blog Dec 07, 2016
Overall, we remain neutral — but the results of the U.S. election could be the catalyst for an inflection point in the markets.
Our overall asset allocation position remains neutral with some scope for above-neutral equity beta. The results of the U.S. election are likely to create a material inflection point for market conditions. Economic policy over the past several years has been almost entirely reliant upon monetary stimulus. But given the Republican sweep, the exclusive reliance on cheap money will give way to a more balanced approach that includes tax cuts, infrastructure spending and deregulation. This should increase nominal economic activity and help corporate profits. While the U.S. equity market in general, and U.S. small caps and financials in particular, have rallied sharply, other areas across world equities have lagged badly and even fallen. Our U.S. equity and cross-sectional equity work point to a catch-up phase where non-U.S. equity markets rally to close the gap in the weeks ahead. Strong seasonal conditions also support a fully invested stance.
Equity: Overall, we remain neutral. Full equity sensitivity remains appropriate. U.S. equity investors clearly support Donald Trump's agenda for corporate tax cuts and deregulation, but international markets remain leery of trade policy. U.S. dollar (USD) strength is the biggest headwind, but we expect strong global equity performance should the USD stabilize, even at current levels.
Within equity allocation: We continue to favor non-U.S. equity markets in general and emerging market (EM) equities in particular. This view was out of sync with investor reaction to U.S. election results, partially due to USD strength and partially due to protectionist fears. Our preference for international markets is based on expectations of a pause in bond yield adjustments and a pause in USD strength. With these pauses, non-U.S. markets should have substantial scope for a period of catch-up with U.S. equity performance. We remain moderately overweight EM equities, moderately underweight U.S. equities and neutral developed market equities. From a size perspective, U.S. small caps remain a moderate overweight, though some tactical profit taking makes sense following the election rally.
Fixed income: Overall, we remain moderately underweight. Duration tools signal that the post-election rate adjustments are sufficient to resolve near-term overvaluation. Also, a December rate hike is currently priced as a near certainty by investors, arguing for less downside from this perspective. While it is reasonable to add some rate exposure now, inflation trends and negative momentum argue that we refrain from upgrading our fixed-income stance at the moment.
Within fixed-income allocation: Our more conservative outlook for interest rate risk remains in place strategically, though we see scope for a tactical break from recent intense bearish trends. We remain moderately underweight Treasuries and international government bonds. Spreads are tight but we do not detect an impulse for widening. We remain neutral high-yield bonds, moderately overweight investment-grade bonds and moderately underweight securitized bonds. TIPS remain moderately overweight in light of a nascent inflationary impulse. Because they haven’t sold off alongside other government bonds, Japanese government bonds emerge as a funding source for relative positioning.
Alternatives: Overall, we remain moderately overweight. While the concept of expanding our diversifying components remains irresistible, the weak performance of alternatives in September is troublesome since our thesis relies upon an incremental diversification benefit from alternatives. But we can change our tactics within alternatives to suit the special circumstances of today’s market environment. Specifically, an explicit search for holdings with a negative downside capture to global equity corrections is warranted. We expect factor efficacy to improve as markets move beyond a strict dependence on monetary policy in the months ahead.
Within alternatives allocation: We remain moderately overweight commodities. Momentum and dynamics remain favorable and commodities offer a potential for tactical catch-up within our risk asset holdings. Absolute return strategies remain modest overweight. The efficacy of active, market neutral and systematic strategies is struggling — perhaps as a function of investor appetite for passive investments. To help with tantrum-specific risk management, a long volatility position can be added either when pricing becomes favorable or as part of a strategy to manage carry cost. We also maintain a moderate underweight for REITs, noting their heightened rate sensitivity.
Currency: We have moved from neutral to moderately overweight the USD and moderately underweight the yen. We remain moderately overweight the Australian dollar and moderately underweight the euro. Currency tools provide a mixed message. Clearly, the Trump agenda is being viewed, appropriately we think, as USD-positive. A stable dollar would be most compatible with our preference for EM stocks and commodities, but we have no basis for an explicit weak dollar view. Also, being long the USD has been a useful component of a tantrum hedge strategy. The pound has weakened enough that we hold a neutral view.