Asset Allocation Views: Easing Into Slowing Growth
We are in a late cycle environment in which macro conditions are increasingly signaling deterioration, and this fact alone calls for nuanced portfolio construction. However, our macroeconomic analysis suggests that the economic softening so far has been largely offset by central banks around the world pivoting to easing, which has loosened financial conditions considerably. Looking forward, it still remains unclear if the loosening of financial conditions will manage to turn the outlook around.
Here is how we are positioning multi-asset allocation portfolios in light of our outlook for the global economy and markets.
Given broadly slowing growth, increasing geopolitical uncertainty, and generally higher levels of volatility, we are modestly underweight risk relative to our benchmark, and are building liquidity to take advantage of tactical buying opportunities.
We expect volatility and slowing profit growth to continue to restrain investor appetite for equities in 2019. Therefore, we have a modest underweight to equities with an emphasis on liquidity and high quality, defensive sectors. We favor large caps over small caps, U.S. equities over European equities, and have increased our weighting in high-dividend-yielding equities, which we believe should benefit from lower sovereign bond yields.
We prefer high quality duration as we move toward the later part of the cycle, as we still believe that fixed income offers an attractive diversifier for risk in portfolios, particularly given the dovish pivot of global central banks. However, we are selective in our exposures. Recognizing the significant moves lower recently, we still find U.S. rates the most attractive in developed markets.
Given our late cycle view, we expect corporate credit will underperform over the coming year. Within corporate credit, we prefer shorter-dated bonds from high quality issuers, especially in defensive and noncyclical sectors, which is in keeping with our quality and liquidity theme. The high yield underweight reflects in particular the glut of low quality leveraged loan issuance. We continue to favor non-agency mortgage-backed securities (MBS) as they remain a relatively stable alternative to corporate credit. We are also selectively receiving rates in select emerging market (EM) external credits where valuations look compelling, and that we believe will benefit from global developed market central banks pivoting to a more dovish rate path.
We favor overweighting municipal allocations as U.S. tax reform has created a favorable technical dynamic for the market. Tax law changes have contributed to a drop in issuance while demand has remained steady, particularly in high-tax states where state and local tax deductions were curtailed. Additionally, in this macro environment, municipal bonds may offer investors a late-cycle refuge with attractive, tax-efficient income. However, credit selection will become more critical as economies cool. We continue to emphasize credits backed by dedicated revenue streams less subject to politics and pensions.
Historically, real assets tend to perform well in late cycle environments; however, that relationship has become less stable in recent periods. That said, we still view real assets as an effective tail risk hedge against rising inflation as well as a portfolio diversifier, and we therefore maintain a modest allocation to what we feel are attractively valued opportunities, including U.S. Treasury Inflation-Protected Securities (TIPS).
We have a nuanced view on currencies, and expect more significant alpha opportunities to emerge outside of the major currencies. The dovish pivot by developed market central banks argues for an overweight to those EM currencies that are both attractively valued and higher yielding. We have paired this risk with an underweight to export-heavy Asian currencies that are closely linked to China.
For detailed insights into our views across asset classes, our systematic framework for tactical asset allocation, our macro momentum model that helps inform portfolio positioning in changing macro crosscurrents, and our approach to equities, please read our 2019 Asset Allocation Midyear Update.
Erin Browne is a managing director and portfolio manager in the Newport Beach office, focused on multi-asset strategies. Geraldine Sundstrom is a managing director and portfolio manager in the London office, focusing on asset allocation strategies. Mihir Worah is PIMCO’s CIO Asset Allocation and Real Return.
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All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Investing in MLPs involves risks that differ from equities, including limited control and limited rights to vote on matters affecting the partnership. MLPs are a partnership organised in the US and are subject to certain tax risks. Conflicts of interest may arise amongst common unit holders, subordinated unit holders and the general partner or managing member. MLPs may be affected by macro-economic and other factors affecting the stock market in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer’s financial condition, or unfavorable or unanticipated poor performance of a particular issuer. MLP cash distributions are not guaranteed and depend on each partnership’s ability to generate adequate cash flow. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Diversification does not ensure against loss.
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