In our Asset Allocation Secular Outlook, “Asset Allocation Without Tailwinds,” published in July, we observed that tailwinds from ever-lower policy rates and lower valuations are behind us. We highlighted the importance of robust portfolio construction and suggested investors could improve outcomes by being tactical and incorporating alternative sources of return and alpha. This post offers a brief update to these views.
Overall Risk Position
Key developments since July include China’s decision in August to relax the yuan’s quasi-peg to the dollar, which shook markets globally. China’s moves in the coming months could have notable implications for other major central banks and for asset prices globally. Adding to uncertainty is when the Federal Reserve will begin hiking rates – December is a possibility.
Against this backdrop, we remain slightly overweight risk assets, but have pared our overall risk posture to mute the impact of a brief drawdown given heightened uncertainty. Our goal is to tactically step back into our high-conviction positions as higher volatility presents attractive entry points.
Equities: We are neutral equities, focusing on country and sector selection, which remain critical. We are underweight U.S. equities given risks of an earnings growth slowdown, especially for multinational corporations. We like U.S. banks, however, given their ties to domestic economic strength, cheaper valuations and earnings momentum. Beyond the U.S., we are neutral Europe and slightly overweight Japan. Within EM, we prefer emerging Asia and continue to retain our exposure to offshore “H-shares” in China and have built a position in Taiwanese equities.
Rates: We are modestly underweight interest rate duration in multi-asset portfolios. Given ultra-low interest rates, we are currently underweight duration in the U.S. and core Europe while respecting the diversification and tail risk hedging benefits of high quality bonds. We maintain small allocations to periphery debt, like that of Spain and Italy, and have neutral positioning in Japan and the emerging markets.
Credit: We continue to favor capital securities issued by European banks and non-agency mortgage-backed securities. We continue to hold select property credits in China, which stand to benefit from monetary easing and potential reforms that are underway.
Real Assets: We like exposure to inflation breakevens in the U.S. as we expect improvements in the labor market will continue to feed positive inflationary pressures. We maintain our neutral position in commodities, emphasizing relative value opportunities across energy, metals and agriculture sectors.
Currencies: Divergences in global growth and policy should continue to fuel the relative strength of the U.S. dollar versus global currencies. We have rotated away from our shorts in the euro and yen toward a basket of emerging Asia currencies. While we expect this position to add alpha, it also acts to hedge unexpected weakness in the Chinese economy.
Please stay tuned for our next annual Asset Allocation Outlook coming at the end of the year.