Asset Allocation Committee Outlook

After a bout of illness, it’s human nature to want to get back into the swing of things. But our sense of recovery often gets the better of our risk management. We head out without a hat and scarf, we swap the flu remedies for coffee, we embrace the stresses of the workplace—and we end up straight back in bed. The arrival of coronavirus vaccines means the economy should eventually get out of its sickbed, but we think investors should take things steady. Short-term stumbling blocks are not confined to the ongoing pandemic: there are underappreciated political and geopolitical risks, too. Even as it gains pace, economic recovery will likely be uneven: hard for many sectors, perhaps impossible for some. And recovery may bring its own risks: stretched valuations in many parts of the market could snap back if interest rates rise faster than expected, and the growing crowd of consensus trades could be a recipe for volatility during the first half of the year. The Asset Allocation Committee (“the AAC” or “the Committee”) has therefore consolidated its positive views on economically sensitive assets, but the “risk on” tenor remains moderate. The first half of 2021 could offer more opportunities to lean into the recovery as it develops.

It is rare to see the level of market consensus that has greeted this new year. Investors appear almost universally to be pricing for an early-cycle mix of low interest rates and ongoing support from both monetary and fiscal policy, combined with the release of pentup demand from consumers and manufacturers. This backdrop is expected to support higher corporate earnings, higher wages, higher consumer prices and higher index levels for risk assets a year from now.

To a large extent, this agrees with the AAC’s latest economic and asset class views for the next 12 months, which consolidate our positive outlook. Where the Committee has changed its views this quarter, it is increasingly prepared to lean into the recovery from the coronavirus crisis. Investment grade credit, with a particular focus on the most interest rate-sensitive sectors, is downgraded; while emerging markets equity is upgraded to an overweight view. That is largely due to the clearing of two big hurdles in November and January: confirmation of successful coronavirus vaccines and more clarity on the post-election landscape in the U.S.

Nonetheless, our current views still express a moderate appetite for risk. While we are not contrarian, we do place more weight on some short- and medium-term uncertainties that could create opportunity to lean into the recovery at more attractive valuations. We would liken our current situation to the end of 2009. A similar nine-month market rally had left investors strongly positioned for a continuation of good news into 2010, and indeed global equities finished 2010 up 9%. On the journey there, however, they traded across a 20-percentage-point range. The S&P 500 Index went on a similar journey, finishing the year with a total return of more than 15% after a second-quarter sell-off that included the notorious “flash crash” of May 6.

Back in 2010, the big risk was Greece’s unmanageable debt burden and the threat it posed to the euro. Today, the major short-term risk is coronavirus, which is likely to continue to disrupt economies until vaccination programs are well advanced. Much of Europe and North America has endured a miserable holiday season under strict constraints due to a winter surge in infections. Health systems are typically under the greatest pressure in the northern hemisphere at this time of year.

Perhaps less appreciated are the political and geopolitical risks that come with a new U.S. administration.

One uncertainty was removed early, as voters in Georgia’s Senate races overturned the market’s preference and expectation for mixed government, giving the Democrats narrow control over both Houses of Congress. This will likely re-ignite debates about how to weigh the potential for extra fiscal stimulus against the probability of higher taxes and tighter regulation, and about the respective timing of those policy changes.

In trade and foreign policy, it remains to be seen how the U.S. will attempt to re-set relations with China and Iran, and even fencemending with the European Union could be complicated by the latter’s aggressive plans to regulate the technology sector. All of this will happen in the shadow of one of the most serious cyberattacks, possibly state-backed, ever mounted against U.S. agencies. Like coronavirus in the first weeks of 2020, we are concerned that one of these could turn out to be the major “sleeper risk” for 2021.

Following a Major Rally in 2009, 2010 Was Positive for Equities—but Volatile

MSCI World Index, USD, 2009 – 2010 and 2020, rebased to 100 on Jan. 1, 2009 and Jan. 1, 2020

The more obvious risks concern the path to recovery in the economy and markets. The economic recovery is likely to be uneven, and even if it goes relatively smoothly, the path of the market recovery is unlikely to be as smooth, given stretched valuations and increasingly crowded trades in a variety of places.

The main area of concern over valuations is in large- and megacap secular growth stocks, particularly in the technology sector. We also see the technology exuberance engendered by the coronavirus lockdowns in the valuations and first-day trading levels of recent IPOs. Given the size of this sector and some of its companies, this is a real risk to index-level return outlooks.

This is where more bullish views on value stocks and cyclical, economically sensitive parts of the equity market, expressed through size, sectors, factors and regions, could be lower-risk— simply because they are cheaper and less crowded. The most crowded trade at the moment sees little probability of the U.S. 10- year Treasury yield going above 1.50% or below 0.65%. Within this range, investors anticipate support for all parts of the equity market, especially if a slight rise in rates is accompanied by a similar rise in inflation expectations (and therefore stable real rates) and continued U.S. dollar weakness.

We share those expectations but remain mindful of the risks. Interest rate adjustments are often more jagged and volatile than underlying changes in the economic outlook. Sudden moves outside of that range could unnerve investors in interest ratesensitive secular growth stocks (on the upside) or cyclical and value stocks (on the downside).

On balance, the AAC sees unexpected upside in rates and growth as the most likely risk. To an existing overweight view on small caps and the more cyclical non-U.S. developed markets, it has therefore added an overweight view on emerging markets equities. While the Asiadominated emerging markets equity indices are surprisingly techheavy, their major factor exposure is long banks and short health care, making them an effective play for global early-cycle recovery.

Overall, however, we still think these views express a moderate appetite for risk. The AAC wants to mitigate exposure to interest rate risk and over-valued parts of the market while also moderating exposure to expectations of economic recovery, which could still prove bumpy over the next three to six months.

Fixed income, where some $19 trillion of paper now has a negative yield, is likely to be more sensitive than equity to any rates volatility. Even a move up to 1.35 – 1.50% on the 10-year Treasury yield could knock 5% or more off the average bond fund’s value—a non-trivial move amounting to almost half the losses experienced during the credit sell-off in March of 2020. Moreover, the suddenness with which fixed income markets tend to adjust makes it difficult to trade these moves tactically.

As a result, the AAC has adopted an underweight view on investment grade, but this remains nuanced. It is still only one notch below neutral because our negative view on core government bonds is balanced by a more positive view on corporate bonds and some areas of municipal bonds and structured credit, where spreads have compressed, but are less likely to widen again substantially. Shorter duration is also favored, which includes bank loans, specialty financing and private debt, all of which offer the potential for floating rates and less crowding than many other credit markets.

We remain neutral on Treasury Inflation Protected Securities (TIPS) and continue to favor commodities. The latter, in particular, appear to have lagged the decline in the U.S. dollar, and are likely to benefit from fiscal stimulus making its way into the real economy—regardless of whether this impulse is strong enough to be felt in core inflation or real yields. Gold and precious metals may benefit from perceptions of fiat currency depreciation.

Elsewhere in alternative investments, the AAC remains favorable toward private equity (See “Up for Debate: Why maintain an overweight view on tech-heavy private equity?”) and underweight in its view on hedged strategies.

We still see opportunities in event-driven strategies as merger-andacquisition activity continues to recover, in distressed as certain businesses and sectors struggle with the withdrawal of emergency support, and in insurance-linked strategies, where pricing is attractive following a third year of relatively high reinsurance claims. Potential volatility in equity and especially currency markets could create opportunities for some global macro and active currency traders (See “Up for Debate: How might investors take advantage of currency market volatility in 2021?”). Overall, however, we see 2021 as a year for more directional exposures, which does not favor the major long/short strategies.

We are not contrarian and we share much of the market’s current consensus. We think it most likely that yields will trade in a range and the dollar will weaken to an extent that supports equity indices, and we do favor more cyclical and economically sensitive parts of the market for both relative value and exposure to the economic recovery. But we are perhaps more circumspect about the risks of the next six months, whether they are exogenous or derived from a spike in interest rates or a stumble in the recovery. As a result, we advocate maintaining some balance in portfolios to cushion against and take advantage of volatility should it occur.

As we already mentioned, we liken our current situation to the end of 2009—which was followed by a 12-month period in which equities traded across a 20-percentage-point range.

Investors who can tolerate that kind of volatility for the next six months or so could take the AAC’s views as a signal to bound out of the sickbed and fully embrace risk. The rest of us may do better by continuing to give portfolios the TLC they need: taking risk judiciously and in a balanced way, ready to lean into the recovery, potentially at more attractive valuations, as it gains traction.