Health Check for Your Asset Allocation: Focus on Quality and Flexibility

In PIMCO’s recent Cyclical Outlook, our colleagues Joachim Fels and Andrew Balls outlined a “growing but slowing” backdrop, with the global economy in the final stages of an economic cycle. This late-cycle phase poses significant challenges to asset allocators. We think the keys to dealing with them are to stay flexible and to focus on quality when structuring a portfolio.

Returns disperse as the business cycle ages

It might not have seemed like it at the time, but in retrospect, in 2009 one just needed to stay invested to generate generally attractive performance over the decade since: Most asset classes did well, particularly on a risk-adjusted basis as market volatility was so low. Yet this year – with its sharp volatility spikes in February and again this past week – has already proven more difficult.

If history is any guide, we expect this volatility to continue. Since World War II, there has been higher dispersion in returns across asset classes as the business cycle has aged (see chart).

Risk factor returns over the business cycle 1995-2018

While there is no complete consensus that the world economy is in the late cycle – and no way to be certain until the peak is well behind us – markets this year are sending strong signals that we are in the second half of the expansion. Typically, equities tend to benefit later in the economic cycle as earnings growth continues and so far, 2018 has been no exception. Global earnings growth of nearly 20% year-over-year (according to the MSCI All Country World Index/Bloomberg) has supported equity markets even as other asset classes have been down.

The challenge for asset allocators

Yet the aging cycle complicates the asset allocation decision. Although equities have historically been the best-performing asset in the second half of an expansion, they tend to suffer as the cycle turns and an inevitable recession follows. While the current U.S. expansion is the second-longest since World War II, acute signs of the end are few, and it is notoriously difficult to predict the turn.