To summarise our macro outlook, we see a lower risk of recession than the market. Central bank action should remain a positive for investors as inflation continues to disappoint, prompting dovish monetary policy. Regarding our active asset allocation framework that aims to track the main risk factors driving asset returns in the long term, what has changed for 2020 compared to one year ago? Although we are repricing in recession risk, diminishing risk-off sentiment and less attractive valuations for growth-oriented assets, our tactical asset allocation remains supportive for growth oriented assets: 1) a positive view on equities and 2) a cautious stance on the usual hedges such as duration and precious metals. Nevertheless, the number and the amplitude of positive factors that prompted us in early September to adopt a tilt toward growth assets in our portfolios have receded after a rally for three consecutive months .
In a nutshell:
- Although the global economy has been slowing for 15 months, we do not believe a recession is on the cards.
- With inflation nowhere to be found, we expect central banks to remain dovish, offering continued support to financial markets.
- While the outlook for growth-oriented assets remains positive, valuations are one area of concern.
- Within our multi-asset portfolios, our preference is for equities and credit, but with much higher discrimination than in the past.
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What are the risks for growth-oriented and other assets?
On the valuation side, investors tend to be nervous when they face rising P/E ratios and high expected earnings growth for next year. After a three-month rally, clearly the valuation factor is no longer a support for growth-oriented assets. Nevertheless, the risk, in our view, is not coming from the numerator of the equation (future cash flows). The key risk is in the denominator (the actualisation factor, i.e. interest rates). Since 2010, absolute returns for most assets have been boosted by liquidity injections and then lower rates, not by an exceptional period of expansion. Sensitivity to duration is now increasing everywhere, from fixed income products through to equities, private equities and private debt. Low rates have a double impact on non-fixed income assets.
Firstly, they improve expected cash flow through the discount factor.
Secondly, they reduce the probability and the impact of tail risk events. Simple numbers confirm this relationship: between 1988 and 2009, the average yearly performance of the S&P 500 Total Return index in excess of Fed rates has been 7.1%. Since 2010, it has been 13%. We observe a similar extra boost in US equity returns in excess of US GDP or US inflation.
In our view, this “implied convexity” puts a clear risk for the future in case of significant expansion. Studies from the NY Fed about Taylor rules and natural rates of interest show that current Fed policy is very accommodative relative to history. The situation is similar in Japan, Europe and the UK. Therefore, if growth-oriented assets are being supported by low interest rates, then higher rates are the obvious risk not lower rates, and these would occur in the case of a market slowdown.
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