Asset Allocation Committee Outlook

Since last November’s vaccine news, financial markets have been “hanging ten” on a swell of cyclical, value and small-cap stocks, and rising Treasury yields. That move, when a surfer balances with all 10 toes over the edge of her board, is possible only on smooth, “glassy” waves. Crosswinds started to grow in the second quarter, however, as economic and inflation data ran hot: rising yields stalled and growth stocks regained their footing. Investors were looking for a change in the weather forecast from the U.S. Federal Reserve, and when it came, on June 16, it introduced notable choppiness into markets. The Asset Allocation Committee (“the AAC” or “the Committee”) expects the choppy waters to persist as the Fed edges nearer to a likely “tapering” decision toward the end of the year. That said, on a 12-month horizon we still think the economic re-opening waves are rideable and that investors will be able to use the potential volatility to add portfolio risk. Our hanging-ten days are probably over. To stay upright now may warrant rooting our feet firmly in the center of the surfboard.

At the end of March, the AAC identified the leading concern for investors as “the recent momentum behind Treasury yields and what it implies for inflation and the trajectory of central bank policy.” Those concerns reached fever pitch through the second quarter.

Between September 2020 and April 2021, the International Monetary Fund estimates that global pandemic-related fiscal support rose by a third, to just over $16 trillion. This helped drive strong growth as economies began recovering from the pandemic shock: by April, Purchasing Managers’ Indices (PMIs) were exhibiting expanding activity in every region of the world, and in some cases hitting all-time highs. The result was headline U.S. consumer prices posting 4.2% year-on-year inflation in April and 5% in May. Core U.S. personal consumption expenditure, the U.S. Federal Reserve’s favored measure of inflation, has risen by 3.1% over the past 12 months, well ahead of the central bank’s 2% long-run average target.

Instead of adding momentum to the nine-month rise of U.S. Treasury yields, however, these surprisingly high inflation data appeared to stop that trend in its tracks. If this seems counterintuitive, in our view it reflects the complexity of current market narratives and the importance of central bank liquidity in the way markets are pricing.

U.S. Inflation Soars to a Post-Financial Crisis High

U.S. Consumer Price Index, all items, year-on-year inflation rate

Leading up to the Fed meeting in mid-June, there was (and remains) a fierce debate about whether current inflation data reflect “transitory” factors (such as the low base set by the pandemic crisis this time last year, pent-up demand for goods and services associated with economies re-opening, and temporary recruitment difficulties) or a “structural” change in the growth and inflation environment.

Many market participants were unnerved at how adamant and coordinated central bankers had become in support of the dovish, “transitory” side of that debate. Rather than pricing for runaway inflation, however, they moderated their exposure to the re-opening trade instead, buying Treasuries and defensive stocks at the margins. The logic was that problematic inflation might force the Fed to tighten its policy earlier than planned, thus choking the recovery—effectively bumping us from an early-cycle to a mid-cycle environment.

When the Fed met in June, its messaging changed. The central bank raised its inflation forecast for 2022 and Chair Jerome Powell acknowledged that “inflation could turn out to be higher and more persistent than we expect.” Federal Open Market Committee (FOMC) members’ expectations for their first rate hike moved forward into 2023. And on the topic of asset purchases, Powell confirmed that the Fed was “talking about talking about” tapering.

Here was a hint of what the market had feared.

On the surface, the response appeared calm. Treasury yields spiked, but quickly settled back to pre-meeting levels. The S&P 500 Index dipped by less than 2% before recovering ground over the following days. Overall financial conditions remained extremely accommodative. The Fed is likely to conclude that it pulled off exactly what it wanted: reassuring us that it has its eye on inflation risk without spooking everyone with its hawkishness.

Look below the surface, however, and there are strong rotational rip tides. Market participants doubled down on the doubts about growth and recovery that began to surface in May. Breakeven inflation rates, the difference between the yields of nominal and inflation-protected Treasuries and a key measure of market inflation expectations, which had been declining for a month, slumped still further. Yield curves flattened as long-dated forward interest rates declined. Equity investors rotated sharply out of cyclical and value stocks into defensive and growth stocks.

Cyclical Stocks and Inflation Expectations Wiped Out in April and May

The AAC does not believe much has changed, fundamentally.

What has changed, at the margins, is investors’ focus on the narrative around whether inflation is transitory or structural and how central banks might react to it: right now, the story is that inflation will prove stickier than we would like, the hawks will become emboldened, tapering will prove disruptive, and early cycle is giving way to mid cycle.

But in our view, there are equally convincing narratives leaning the other way: the economic data could cool off, or investors might notice that the leadership of the Fed is more dovish than its broader membership and its “dot plot” suggest. Indeed, within a week of its June meeting, the Fed leadership was urging investors to focus less on potential hikes in 2023 or talk of tapering and more on how accommodative their current plans are.

That pattern is how the Committee thinks the rest of 2021 is shaping up: elevated volatility in sentiment and market pricing, derived from a new tension in central bank messaging, which could provide opportunities to add portfolio risk in accordance with our medium-term views.

Tactically, then, we would have used the negative-growth sentiment evident beneath the markets’ surface in May and June to implement positions in line with those views, which remain pro-growth. Indeed, where the Committee’s views have changed from last quarter, they have become incrementally more favorable on equities and other risky assets.

Our view on investment grade fixed income is downgraded to underweight on lower yields and tighter spreads. Treasury Inflation Protected Securities (TIPS) remain at a neutral view. High yield remains at an overweight view, with a bias toward the floating rates available in loans and collateralized loan obligations (CLOs) over fixed rate bonds; but most Committee members noted that, in a multi-asset class context, they would now prefer equities over the tight spreads in credit.

Along the same lines, the AAC upgraded its view on U.S. large-cap equities to neutral to reflect its broad-based positive view on equities, particularly against investment grade bonds. That clearly adds net risk overall, but by adding exposure to the large growth and defensive names that dominate the U.S. large-cap segment, its aim is also to balance our overweight views on small- and mid-caps, our preference for value and cyclical stocks, and our pro-cyclical regional views. Non-U.S. developed and emerging markets equities retain their overweight views, as does emerging markets debt. We believe the recent comeback for the U.S. dollar is a reaction to the marginally more hawkish Fed messaging that is likely to fade over time, lending support to these non-U.S. markets.

Commodities are more sensitive to short-term spikes in inflation than the medium-term growth trajectory, and after six months of very strong performance the AAC has less conviction in its overweight view. Nonetheless it remains in place, as we think some vulnerability in the agriculture complex is offset by more upside potential in energy and industrial metals.

All that said, the AAC also acknowledges the likelihood of elevated volatility, as interpretations of the inflation and central bank policy narratives flow back and forth with new data and new messaging from Fed members.

What we have now are what surfers would call “blown-out” waves: still rideable, but choppy and difficult. Hanging ten on the predictable, glassy swell of the reflation trade has given way to the need for a more balanced stance, the better to stay upright amid the narrative crosswinds.

That comes across in our upgrade for U.S. large caps—the equivalent of shuffling back to the middle of the surfboard in risky assets. We reflect it in our anticipation that the next six months may call for more frequent tactical trading, with tighter risk parameters for triggering exits from positions. And it is also evident in our continuing overweight views on private equity and private debt, where quality and earnings growth justify current high valuations, and where value can be added through operational improvements to businesses, away from the potential volatility of the public markets. In addition, the Committee is expressing an overweight view on private real estate, reflecting the improving fundamentals of this segment as economies reopen, as well as its positive sensitivity to inflation. The Committee noted that REITs should also benefit from these dynamics.

While the AAC thinks that short- and medium-term negative-growth sentiment is overdone, it is worth ending with a glance over the 12-month horizon, where we think the clouds may be darker.

To extend our surfing analogy, the question is whether the pandemic was merely a storm depression whose passing will return us to the familiar calm waters of an extended, moderate, post-financial crisis style expansion, or a force profound enough to have raised the growth tide and reshaped the seabed into a generator of persistent wave activity.

Financial markets appear unwilling to price in a major break from the past. U.S. breakeven inflation rates for the next five and 10 years have fallen back to less than 2.5%. More strikingly, one-year forward interest rate swaps suggest that U.S. rates will likely struggle to break 2% before 2026, at which point rates in the Eurozone and Japan will still be barely above zero.

Rates Markets Are Pricing for Secular Stagnation

One-year forward USD Libor, Euribor and Euroyen Tibor interest rate swaps

This accords with consensus estimates which see global growth declining from 6% this year to under 3.5% by 2023, U.S. growth going from 6.6% to 2.3%, the Eurozone settling at 2% and China at 5.5%. For the U.S. and Europe, those rates are only slightly higher than the average of the past 20 years. China’s is considerably lower. This is despite the $16 trillion of global fiscal stimulus combatting the economic impact of the pandemic: indeed, even with the longer-term elements of the U.S. spending packages in place, we think the expiration of stimulus measures is likely to result in a negative fiscal impulse as early as the middle of next year. A rising tax burden to pay for those measures may also begin to drag on growth and corporate earnings.

While evidence of strong multiplier effects or wage inflation could persuade us to change our view, the AAC therefore anticipates a return to something like the conditions of the post-financial crisis years by 2023 – 24. That may begin to impinge upon our 12-month asset class views as we move into 2022. For the time being, however, we are steadying ourselves on our surfboard, waiting to catch the next wave of the post-pandemic re-opening.