Asset Allocation Committee Outlook

While the Asset Allocation Committee’s (“the AAC” or “the Committee”) headline views looking out over the coming 12 months have not changed notably this quarter, our discussion certainly has. The consensus remains cautiously positive on the economic and market outlook for the coming year but, for the first time in 18 months, and particularly among members of our fixed income team, we have started trimming risk in our views, advocating reducing exposure and building dry powder to take advantage of opportunities that arise due to potential short-term market volatility. The immediate hurdles that we believe investors need to clear include supply disruptions and rising input costs (particularly energy), tighter fiscal and monetary conditions, and threats to growth in China. These near-term challenges could lead to slowing growth and stubborn inflation. As a result, while our views remain largely consistent and oriented toward risk exposure on a 12-month horizon, we are looking to be more defensive in the short term. That raises a challenging question: Which markets do we favor, when stock market valuations are stretched and core government bond yields remain so low?

Three months ago, the AAC was preparing to move from smooth to choppy waters, as a descent from the “peak growth” of early summer coincided with the prospect of tighter monetary and fiscal impulses in 2022, feeding into higher uncertainty and volatility in the markets. This was not about assuming a defensive stance in our views, however, but about achieving a balanced risk outlook that would enable us to lean into risk-on views should volatility present the opportunity. The AAC believed that the next 12 months would be choppier for risky assets, but ultimately positive.

Our headline views show little change as we move into the final quarter of 2021. But the tone of our debate has arguably shifted more substantially than it has for a year, reflecting a growing consensus that we are getting closer to the point at which early-cycle recovery shifts into mid-cycle expansion. On a 12-month horizon, that still looks to us like an attractive environment for risky assets, but the inflection point is already proving particularly volatile. We think it is prudent to position still more defensively for the short term, to be better able to clear the immediate hurdles.

The terms of reference have evolved somewhat, but the twin threats of stubborn inflation and slowing growth identified by the Committee remain essentially unchanged. Concern that very high inflation might turn out to be structural rather than transitory has given way to worries about the problematic nature of current price pressures (see “Up for Debate: Inflation—Not a Question of Transitory Versus Structural”). And while rogue variants of the coronavirus remain a threat, China’s recent reframing of its business and social regulations, which appear to accept short-term disruption and slowdown in exchange for progress on longer-term policy goals, has risen to become the AAC’s top risk to global growth (see “Up for Debate: All Change in China?”).

These risks have now grown prominent enough to elicit the first sustained notes of caution from Committee members for more than a year, particularly those from our fixed income team. While there is still debate within the team about the urgency and speed of these moves, in multi-sector portfolios, for the first time in 18 months they favor taking advantage of spread tightening to sell credit risk rather than taking advantage of selloffs to add it.

This shift in sentiment is partly due to fundamental concerns about the turn in fiscal and monetary policy impulse, the stickiness of inflation and the descent from peak growth, but it is also partly due to perceptions that it is no longer worth taking so much risk. Spreads are already tight; but, in addition, there are a lot of investors whose profit-and-loss statements currently show 18 months of strong recent returns which may represent a good opportunity for reducing risk now.

Those taking the other side of the argument point out that there is still upside to be earned going into year-end, but also note the lack of cheaply priced safe havens to rotate into. Some fixed income AAC members think it best to wait for higher Treasury yields, both as a signal of a turn in the credit cycle and as a destination for capital. Indeed, while the fixed income team’s multi-sector portfolio managers have started to reduce credit risk, they also remain as short in duration as they have been since the start of the pandemic.

EQUITIES DO NOT YET APPEAR TO BE PRICING FOR THE DESCENT FROM PEAK GROWTH

 

The debate is similar on the equities side of the Committee. We still see quite a lot of implied volatility priced into options—so these are not overly-complacent markets. Similarly, the valuation dispersion in U.S. stocks—the difference between the P/E valuations of the most expensive stocks versus the median stock in the index, or, essentially, how much value there is in the index’s cheapest stocks—remains surprisingly high. Nonetheless, it is questionable whether current valuations have really taken account of the apparent peak and modest downturn in the economic cycle. To reiterate, these inflection points are tricky to navigate, and there may be some adjustments to come over the coming weeks.

Investors who can clear the hurdles without tumbling are likely to be in a much better position to take advantage of the potential opportunities of a more settled mid-cycle expansion. Let’s not forget that many fundamental indicators remain very positive.

So far, we are seeing a growth plateau rather than a steep descent, supported by $3.5 trillion of excess cash on household and corporate balance sheets, relative to the pre-pandemic trend; rising wages; increasing capex; and a near record ratio of new orders to inventories across several industrial sectors. Consumers are likely to want to spend big on seasonal holiday celebrations after last year’s disappointments. Financial conditions remain very accommodative, and while the Federal Reserve and the European Central Bank have signaled an impending start to tapering asset purchases, they appear to have successfully separated this action from any suggestion of imminent rate hikes.

On balance, while this is not yet translating into substantial changes in our headline views, nor indeed its overarching view that potential market volatility remains an opportunity to lean into risky assets, the tone of the debate has changed, and the tenor of our short-term views has grown more cautious. That means the Committee faces a similar challenge to that of the fixed income team: Which markets do we favor? Our view on cash is upgraded to neutral, and some AAC members have started leaning towards Hedged Strategies, but views on expensive core government bonds remain firmly underweight.

Regional relative valuations help us here.

While non-U.S. allocations in equities and fixed income are not lower-risk in terms of their gearing to global growth, they may be lower-risk in terms of current valuations, and positively exposed to any weakness in the U.S. dollar. As such, the AAC retains its overweight view on emerging markets and developed market non-U.S. equities, with highest conviction on Europe and Japan, and downgrades its view on U.S. large-cap equities to underweight.

NON-U.S. MARKETS MAY BE LOWER-RISK IN TERMS OF VALUATION

We acknowledge that the major economies in the non-U.S. markets face particularly heightened political risk right now. Germany’s tight election looks likely to end in the country’s first three-party coalition government, led by the center-left Social Democratic Party—but negotiations could be complex and lengthy. With Japan’s prime minister Yoshihide Suga opting to step down as leader of the Liberal Democratic Party after a much-criticized tenure struggling to control the COVID-19 crisis, the ruling party heads into November’s wide-open general election, with Fumio Kishida at the helm. Above all, markets are still grappling with the implications of China’s regulatory pivot (see “Up for Debate: All Change in China?”).

That said, U.S. political risk is also high. Congressional negotiations around both the debt ceiling and President Joe Biden’s multi trillion-dollar fiscal bills—and the taxes to pay for them—are likely to be at a crunch point as this report comes out. Looking longer-term, investors appear a little complacent about the regulatory vulnerability of the market-leading mega-cap technology companies over the next year or two.

AAC members that remain more bullish about year-end prospects see the favoring of non-U.S. markets, together with an ongoing preference across the Committee for value over growth stocks and sectors, as a continuation of our reflation-and-recovery views. Nonetheless, there are also reasons for this non-U.S. tilt to color the Committee’s more defensive short-term views.

Alternative investments are another place to look when one is downgrading views on public equities but reluctant to upgrade views on core government bonds.

The Committee’s headline view on Hedged Strategies remains underweight, but it is growing marginally more favorable and behind it lies a diversity of views on specific strategies. Many of the classic market-neutral styles, from long/short equity and statistical arbitrage to capital-structure arbitrage, have struggled again so far this year as market indices have risen steadily. Macro and trend-following strategies continue to find it difficult to implement sustained and differentiated ideas, beyond simply being long risky assets, in an environment of massive government intervention in the economy and markets. Things may change for these classic styles should volatility return in earnest—but there is no guarantee that the nature of that choppiness will suit them. Structured credit, particularly in U.S. mortgage securities, has been fruitful in the aftermath of the pandemic, but the opportunity set has become less abundant.

The opportunity set looks stronger for event-driven strategies, however, as this year’s merger-and-acquisition frenzy seems set to continue, while special situations and distressed are likely to benefit from the potential turn in the cycle next year. And while many insurance-linked strategies are grappling with the enormous liabilities created by Hurricane Ida and Germany’s summer floods, compounded by supply-side price pressures on labor and materials for reconstruction, this could signal an attractive entry point for new investors.

The Committee has higher conviction on private markets. As we have been reiterating for many quarters, now, while private equity carries equity risk and comes with high valuations, those valuations remain competitive relative to the public market, as well as less volatile on investors’ profit-and-loss statements. The sector’s ability to create value away from the volatility of the public markets can also address some of these concerns. Moreover, the high multiples being paid, together with the high level of equity in most current deals—more than 50% is now becoming the norm—is concentrating the minds of private equity managers on high-quality companies with strong organic growth prospects.

The Committee also recognizes that there are some very attractive specialized opportunities to be explored in private markets and singled out structured preferred stock capital solutions for private companies. These businesses have growth projects to finance but are unable to raise more senior debt. Preferred stock can help bridge the gap, and for investors willing to take some illiquidity risk and payment-in-kind rather than cash-pay coupons, it has the potential to offer a near-equity return outlook, with credit-like terms, at around half the valuation multiple of the same company’s common equity.

Finally, the AAC held its overweight view on commodities, as one of the few reliable ways to hedge against the potential for cost-push, supply-side inflation pressures to persist or even worsen into year-end and beyond. The picture is complex, however. Additional supply is likely to soften prices for many agricultural products, and potentially also for some metals. Energy is the real wild card, and especially natural gas: on top of pandemic-related supply constraints, which have compounded years of underinvestment, the northern-hemisphere winter and a pick-up in seasonal travel looks likely to add demand pressure onto an already fragile market.

While the AAC’s headline views have not changed notably this quarter, our discussion certainly has, and the tenor of our short-term views has grown more cautious. Our view on cash is upgraded to neutral, we favor select Hedged Strategies, and our view on U.S. large caps is downgraded to underweight to reflect greater caution on valuation risk. Overweight views in asset classes such as high yield and emerging markets debt remain in place but are under closer scrutiny in the immediate term. Core government bond yields are still too low to be attractive, but they have risen quickly and could be favored alongside cash over the coming weeks. Once the current inflection point in the cycle has passed, and its associated hurdles safely cleared, the Committee anticipates a return to a set of 12-month views that look more like those it held six months ago.