Asset Class Opinions as of January 13, 2020
Bonds and Stocks
Our Global Tactical Allocation strategy is overweight equities on the basis that the economy is healthy, unemployment is low, and consumer confidence is generally sound. We believe that fiscal and monetary stimulus turned positive almost a year ago and, given the typical lagged effect of policy changes, we would not be surprised to see the accommodative stance support the market into the new year. Furthermore, an uptick in global economic surprises suggests that earnings estimates may soon move higher, particularly for cyclically sensitive groups.
Governments and Credit
With strong profits and cash flows, we expect defaults to remain very low and, therefore, expect credit spreads to flow through to returns. The yield pickup from owning investment grade bonds is attractive and interest payments are well covered by corporate cash flows. Government yields relative to inflation are not attractive at these levels.
Investment Grade and High Yield
Economic conditions kept defaults low in 2019 and high yield bonds and bank loans have performed strongly, leading to tight credit spreads. We believe the risk/return tradeoff of lower-rated bonds versus investment grade corporates is neutral at best. If economic growth were to weaken, high yield could quickly fall from favor. We have no position in high yield at this time.
Higher and Lower Rates
Interest rates seem to be in a steady, neutral range. Inflation remains tame and foreign bond yields are negative in many countries; both of these conditions suggest little upward pressure on longer U.S. rates. We are positioned with a slightly shorter duration even though signs of a pick-up in inflation, which would hurt longer assets, are not yet compelling.
Weak and Strong U.S. Dollar
While we are looking for a potential turn in the strong dollar trend, we are fully aware that the Fed easing in 2019 was a necessary, but not sufficient, condition for the dollar bull market to end. Previous dollar bull markets ended in two different ways: 1) in 2001, U.S. growth started to lag global growth while global trade troughed and began to rebound; 2) in 1985, a political intervention (the Plaza Accord) was the catalyst. Right now, the first scenario is more likely than the second, but we are not quite there yet.
Domestic and International
International equities carry a normalized P/E ratio that is just two-thirds that of the U.S. market. We expect business activity in Europe to improve this year, as economic surprise indicators are suggesting a positive environment is developing. U.S. growth has been strong recently, but that relative advantage may be about to narrow. We have slightly increased our European exposure within our overall international exposure, and we remind investors that an important historical trend to watch for is the potential for a U.S. market selloff to flip investor preference from recent winners (domestic stocks) into a rotation move toward international stocks.
Developed and Emerging
Our research suggests that, as a high-beta risk play, Emerging Markets typically fall early in a down-cycle but then lead Developed Markets off the bottom. We also believe EM is one of the best plays on a weaker U.S. dollar. As the largest Emerging Market country, China’s growth rate and a resolution of trade issues are important drivers for EM gains, with some thawing in the trade tensions starting to appear. We have increased our EM position to a slight overweight to reflect these potentially positive developments.
Value and Growth
Recent market turmoil failed to flip the style derby from Growth to Value. Often, a market turn will produce a change in leadership, but the difficulty today is that Value tends to be loaded up with Financials, Energy, and Cyclicals, whereas Growth sectors are still in favor. While we are intrigued by the valuations offered in cheaper segments of the market, their continued poor price action keeps us slightly underweight Value. Currently, we prefer Growth and High Quality, which have remained market leaders early in 2020.
Large and Small Cap
Investors continue to favor large cap Growth stocks. We are amazed that 40% of the smallest companies (by market cap) are losing money in what is widely seen as a strong domestic economy. However, small cap valuations recently fell to an attractively low level, and we have added an initial allocation to small caps to reflect that contrarian valuation opportunity. If our view on accommodative economic and monetary stimulus comes to pass, we will consider additional small cap exposure as a pro-cyclical position.
Defensive and Cyclical
Growth and Quality have been consistent outperformers of late and we are overweight both. Investor concerns over slowing earnings growth make the number of companies that are growing, scarcer, and therefore more valuable. A falling discount rate also benefits the Growth style over Value. Furthermore, the desire of equity investors to own safer assets has caused the valuations of defensive stocks to remain high even though their growth rates are below average. We believe it will take a significant shift in market sentiment to knock Growth off its perch.
REITs: Negative and Positive
REITs have performed well and are considered one of the safe-haven yield plays. Valuations are high, however, and interest rates continue to be a key macro driver. We are not willing to chase REITs but would be interested if valuations pull back a bit.
Commodities: Negative and Positive
Industrial commodity prices have strengthened recently, reflecting diminished recession worries as we enter 2020. Energy remains volatile but uninspiring. Our expectations are for solid economic growth in 2020, but until that appears, we are reluctant to take a position in commodities. Our expectation of a weaker U.S. dollar could help commodity indexes, but we think there are better ways to play that macro trend.