With critical policy pivots on the horizon, investors should approach asset allocation with full appreciation for downside risk and stay focused on relative value and security selection.
Investors have enjoyed economic stability and positive market returns for years, but stretched valuations and a changing macroeconomic backdrop suggest a change is coming.
Balancing the risks against a backdrop of buoyant markets, it is a good time to pause and scan the horizon for new directions the markets may take. And after reviewing the landscape, we conclude that the lack of near-term positive catalysts combined with current valuations does not offer sufficient margin of safety to support a risk-on posture. While we wait for clarity on key risks or more attractive valuations, we are focused on quality sources of yield to increase portfolio carry while still keeping some dry powder.
With the macroeconomic backdrop evolving in the face of potentially negative pivot points and considering asset prices generally are fully valued, we are modestly risk-off in our overall positioning. Note this is a shift in our views from the start of the year. We encourage investors to consider actively managing their portfolios, emphasizing relative value and security selection. We recognize events could still surprise to the upside, but starting valuations leave little room for error.
While we are more constructive on equities relative to other risk assets, in light of the recent rally we are maintaining an underweight to U.S. equities. Potential changes to U.S. tax policy and regulation may provide further support to domestically oriented U.S. corporations, while continued USD weakness would support the export-oriented sector. We are moderately bullish on European equities, with growth in the region above trend and an accommodative ECB. We currently have a small positive allocation to EM as a long-term value play.
We remain defensive on interest rate exposure. However, in contrast to the equity market, we find the U.S. the most attractive. Beyond the U.S., we find UK gilts and Japanese government bonds rich, and we believe valuations of eurozone peripheral bonds are suspect without continued ECB support.
At this later stage in the business cycle, investors should appreciate the limited spread-tightening potential of corporate bonds as well as the downside potential for defaults or spread widening. Our credit allocation is focused on non-agency mortgage-backed securities, which will likely continue to benefit from an ongoing recovery in the U.S. housing market and remain well-insulated from many global risks. We also focus on bottom-up security selection informed by our rigorous global credit research.
We maintain an overweight to real assets, with a focus on U.S. Treasury Inflation-Protected Securities (TIPS). Inflation expectations have risen recently, yet we believe there is still value in TIPS as the market is underpricing U.S. inflation risk. While we expect U.S. inflation to remain muted in the near term, longer-term risks remain. We have increased our allocation to real estate investment trusts (REITs) as valuations are attractive given their recent underperformance.
We continue to favor small tactical positions in some of the higher-carry “commodity currencies” given still-attractive valuations. Asian economies have benefited inordinately from global trade, but are likely to weaken in the face of slowing Chinese growth.
For in-depth insights into our asset allocation views both in the near term and over the secular horizon, please read the Asset Allocation Outlook Midyear Update.
Mihir Worah is CIO Asset Allocation and Real Return. Geraldine Sundstrom is a managing director and asset allocation portfolio manager.