Asset Allocation Committee Outlook

As we enter the new year, most of the global economy appears fundamentally in good shape, as demand continues to recover from the pandemic and supply chains are gradually restored. That outlook makes the case for holding risky assets. There appears to be little risk to income or “carry” from dividends and coupons, in particular, as analysts’ forecasts for earnings and defaults remain positive. The Asset Allocation Committee (“AAC” or “Committee”) is less sanguine about price volatility, however. Despite the recent spread of the Omicron variant, our primary concern is no longer the coronavirus, which, against vaccines and anti-viral treatments, can be disruptive but seems unlikely to result in the major lockdowns of 2020. Instead, our concern centers on the likely transition to an environment of persistent high inflation and higher interest rates. Higher discount rates imply lower present values for equities and bonds, particularly given current valuations. Pricing in a risk premium for central bank policy errors is likely to add to the potential volatility, in our view. For the AAC, that means 2022 is a year to focus on income from risky assets, while adjusting portfolios to help cushion against, and take advantage of, potential price volatility.

The International Monetary Fund forecasts 4.9% growth for the global economy in 2022. For the U.S., the Federal Reserve (“Fed”) expects 4.0% growth. Many confidence-related, lagging elements of GDP growth, such as inventories and capex, have yet to catch up with long-term trends. According to FactSet, analysts expect S&P 500 Index earnings to grow by 9.2% this year. Fitch Ratings anticipates a mere 1% default rate for U.S. high yield.

In short, business is expected to hum along nicely, with little apparent threat to dividend and coupon income. The AAC shares this outlook on fundamentals, but we are less sanguine about potential downside and volatility in asset prices as we move into 2022.

Where do we see the risks? Twelve or 18 months ago, it would have been coronavirus. Now, we regard the pandemic as a disruptive rather than potentially catastrophic risk. Instead, persistent inflation and the potential for central bank policy errors are our top concerns.

We saw the same reprioritization of risks by central banks in December’s flurry of activity. In Europe, Norway and the U.K. had among the highest recorded numbers of Omicron variant cases, but both of their central banks raised rates to combat inflation— Norges Bank for the second time in this cycle and the Bank of England (BoE) for the first time in more than three years.

Elsewhere, the European Central Bank (ECB) almost doubled its estimate for Eurozone headline inflation in 2022, to 3.2%, and announced that it would taper its Pandemic Emergency Purchase Program by March (albeit cushioning the blow by planning a temporary expansion of its existing asset purchase program). Even the Bank of Japan signaled an end to its corporate bond and commercial paper purchases in the first quarter of this year.

In the U.S., the Fed doubled the pace of its tapering, committing to end all asset purchases by March (the minutes of its December meeting, published in the New Year, also revealed an appetite for a rapid runoff of the central bank’s balance sheet, or “quantitative tightening”). Its “dot plot” of rate forecasts now suggests there will be three rate hikes in 2022. This is a remarkable change of tone: as recently as September, it was not even sure there would be one. Chair Jerome Powell also sounded notably more hawkish on inflation and the jobs market, and the Fed’s 2022 headline inflation forecast for 2022 was revised up from 2.2% to 2.6%.

The persistence of high inflation in the second half of 2021 has persuaded policymakers that they have to act, and their projections suggest that they are confident they can tame it next year—but not get it back to their long-term targets. We believe that creates a lot of uncertainty for investors for three reasons.

First, it has been at least a generation since the major central banks have faced this level of inflation pressure; the overwhelming weight of institutional thinking has been on how to combat disinflationary forces. Second, if today’s inflationary forces are mainly supply- rather than demand-driven, it is not clear that central banks have the tools to address them without simply slowing growth. And third, structural forces may be causing more persistent high inflation, from China’s economic reorientation and the re-thinking of global supply chains to the fight against climate change.

What does that mean for our asset-class views?

Simple arithmetic suggests that higher discount rates are likely to translate into lower valuations for both equities and bonds. Historical correlation suggests that a 0.15% rise in real rates translates into a point off of the S&P 500 Index multiple, for example. Add on a risk premium for the uncertainty around central bank policy and the path of inflation, and the steady income we anticipate for 2022 could be accompanied by elevated volatility in asset prices.

LOWER INFLATION, BUT STILL WELL ABOVE 2%, IS FORECAST FOR 2022

 

REAL RATES APPEAR TO BE A MAJOR DETERMINANT OF EQUITY MARKET PERFORMANCE

End-month S&P 500 price-to-earnings ratios and U.S. 10-year real yields, January 2018 to October 2021

 

Based on economic fundamentals, the AAC retains its moderately positive view on risky assets. It favors equities over credit— particularly as credit may be more sensitive to a withdrawal of central bank liquidity and higher rates; and it favors credit over government bonds.

Within equities, however, we particularly favor value over growth for its potential to help buffer against downside risk to multiples, and its lower interest-rate sensitivity. So far, mainstream large-cap growth has been resilient in the face of potentially tighter monetary conditions, but we have started to see re-pricing on the more leveraged parts of the spectrum, such as pre-profitability IT and biotech. Most of all, we see an opportunity for a comeback in a subset of value, equity income: it has tended to exhibit even less interest-rate sensitivity; and should volatility become elevated, we think investors are likely to place a premium on a steady, growing stream of dividends.

Within credit, we retain a general tilt to high yield, while acknowledging a little more caution. The likelihood of a low default rate must be considered alongside the potential for volatility and pockets of illiquidity. It follows that we think performance this year will be due more to carry than spread tightening, and that tactical trading on spread widening may be necessary to generate incremental return opportunities. As in equities, lower interest-rate sensitivity, or shorter duration, is a priority: we believe it is more prudent to seek additional return potential from liquidity risk rather than interest-rate risk, leading to a positive view on loans and private debt, which offer floating rates and also the potential for robust demand to feed the ongoing private equity and M&A recovery.

Regionally, the outlook remains complex.

In our view, a mid-cycle expansion should help support the more cyclical non-U.S. economies and markets, just as we expect it to help support more cyclical sectors. The strengthening U.S. dollar of the past seven months has been a major factor preventing non-U.S. outperformance, but we see signs of an end to that momentum: European and U.S. inflation forecasts are now fairly aligned and, particularly with President Joe Biden’s “Build Back Better” stimulus now in doubt, there is greater potential for non-U.S. economies to raise their share of global GDP growth. We therefore remain overweight in our views on European and Japanese equities (and underweight Bunds and Japanese government bonds).

A WEAKER U.S. DOLLAR COULD FAVOR NON-U.S. MARKETS

 

This would normally be a favorable background for emerging markets. On this occasion, however, the AAC has decided to downgrade emerging markets equities to neutral.

There are a number of factors behind this decision: many emerging countries have already been forced further into their rate-hiking cycles than their developed-world peers; political and policy uncertainty is rising, notably in Latin America and Turkey, but also in emerging Europe; the emerging world is highly exposed to slowing growth in China; and it has fewer options for mitigating the ongoing impact of the coronavirus pandemic. The AAC’s overweight view on emerging markets debt remains in place, but our estimation of tail risk has risen: this view will be held with caution until there is more clarity on the path of global growth and the U.S. dollar.

With equity and bond valuations stretched and at risk from rising real rates, the Committee reiterates its positive views on alternative investments that can potentially offer uncorrelated returns, excess returns generated away from the volatility of the public markets, mitigation of traditional asset class volatility, or returns derived from volatility itself.

We upgraded our underweight view on hedged strategies to neutral, with a particular focus on market-neutral and uncorrelated approaches, including insurance-linked strategies. The view might have been more positive were it not for the difficulties many macro investors have experienced over the past two years: dispersion between managers has been extreme.

We maintain our overweight view on commodities, as a portfolio diversifier and for exposure to further potential inflation surprises.

Private markets remain in favor, partly because they do not reprice with the same volatile frequency as the public markets; partly because valuations generally remain attractive relative to those in public markets; but mainly because private equity managers have more ways to improve operations and margins than public equity managers, and are therefore less reliant on multiple expansion for returns.

COULD WE BE RETURNING TO A HIGHER-VOLATILITY ENVIRONMENT?

CBOE S&P 500 Volatility Index (VIX)

 

Finally, for those looking for potential sweet spots in the search for income in a volatile environment, the Committee takes a positive view on equity index put option writing. Writing puts is akin to selling insurance to equity investors, for a premium, against downside risk and elevated volatility. It has a long history of generating equity-like returns with meaningfully lower volatility, and it has tended to perform particularly well during periods of elevated volatility, when put option buyers are willing to pay more for insurance. Incidentally, now that traded options are available on Bitcoin, more adventurous asset allocators might wish to explore the very high premiums available for writing puts on this relatively new, extraordinarily volatile digital asset.

There is perhaps no better example of how put writing can generate carry from sometimes extreme volatility expectations, which, in our view, is what makes it especially interesting now. With the equity and credit income we anticipate over the next 12 months making the case for a positive view on risky assets, but with heightened uncertainty as interest rates adjust, we think those two words, carry and volatility, may sum up the year ahead.