Asset Allocation
Any recovery in risk assets and selloff in safe havens is unlikely to extend into the cyclical horizon.
Last month, the model outperformed both global and U.S. equities in local-currency and U.S.-dollar terms. For February, the model is aggressively increasing its risk exposure and has included a bet on commodities for the first time since 2012. For equities, the largest overweight remains Europe, but EM and Canada enjoyed significant upgrades. For bonds, the model favors the European periphery.
We are introducing a quantitative equity country allocation for the MSCI World universe. Currently the model recommends overweight U.S. and eurozone while underweight Japan, U.K., Canada and Australia, broadly in line with our judgement except that we are more bullish on Japan than the model.
The setback in global financial markets has not been enough to persuade the FOMC to alter its stance. Although the Fed is signaling that the tightening cycle has further to run, the U.S. dollar is showing signs of fraying at the edges.
The Fed will upset the rebalancing of oil markets if it misreads the current sell-off as weakness in oil demand.
The U.S. corporate re-leveraging cycle is far more advanced than is widely believed. Corporate health looks only mildly better excluding the troubled energy and materials sectors. Mushrooming leverage ratios are not restricted to junk issuers either.
Central banks follow backward-looking indicators but economies follow forward-looking indicators. So which indicators should investors follow? And what is the current message? Also, we see signs that London is cooling.
Corporate profits are more sensitive to selling prices than to volumes. Falling prices even amid mildly rising volumes could produce a meaningful profit contraction. Stay with deflation trades. In particular, maintain the short EM stocks / long U.S. 30-year Treasurys position. Indian stocks are still pricey and will deflate further in absolute terms.
The declining correlation between risk assets and Treasury yields suggests that the market perceives monetary policy to be overly restrictive. Historically, this has led the FOMC to adopt a more dovish policy stance.
With inflation expectations declining alongside asset prices in almost every major economy, central banks can at least not make things worse by being more hawkish than necessary.