An Asset Allocator’s Guide to 2017
Markets seesawed through much of 2016 and, by the eve of the U.S. Presidential election, the S&P 500 Index was up barely 5% for the year, while global markets were up even less. Following the U.S. Presidential election, however, equities moved sharply higher, with the S&P closing out the year up almost 12% while Treasury yields rose above 2.5%.
Will 2017 continue to favor risk assets or will the combination of higher rates and richer valuations help end the cycle? In formulating our 2017 outlook, we asked ourselves three key questions: Does the macroeconomic backdrop support risk-taking? What is the nature and level of risk across assets? And finally, are investors well-compensated today for taking risk?
Perspectives on Macro, Risk and Valuations
From a macro regime perspective, we note that a generally positive—if modest—global growth environment should favor equities and credits over government bonds. Our risk team makes the case for the recent rise in interest rate volatility to spread to other assets. Finally, our quant team explores valuations from a total-return perspective across asset classes and a relative-value perspective across risk premia.
Current Portfolio Positioning
Our overarching view is that, while 2017 brings unique challenges, cyclical factors could drive relatively expensive assets such as U.S. equities and the dollar higher in the near term. Our current positioning is as follows:
- Overweight the U.S. dollar versus other developed market currencies.
- Slightly overweight equities, particularly in emerging markets and the United States.
- Long emerging market currencies and bonds.
- A significant allocation to low-duration income assets, particularly loans and catastrophe bonds.
- Underweight duration in developed market government bonds.
Macro Focus: Positive Environment for Risk Assets?
The world economy is experiencing positive cyclical dynamics with reaccelerating momentum in developed and emerging markets. While growth rates remain modest, this broad-based financial expansion represents an important improvement compared to the poor macro picture in late 2015 (see Chart below).
Developed Markets: We anticipate above-trend GDP growth in the United States and Europe, with further improvement in the first half of 2017. While modest returns are likely given the extended duration of the business cycle, we anticipate a “mini-expansion” that favors equities and credit over government bonds.
Emerging Markets: We believe that the 2016 recovery will continue, particularly in Asian countries, but at a muted pace compared to historical standards. We see opportunity in equities and currencies of commodity-linked countries, as well as select emerging market currencies with cheaper valuations.
Improved U.S. Credit Conditions, but Long-Term Risks Building
After credit markets experienced a rollercoaster ride in 2016, our near-term outlook is more constructive given the broad-based rebound in global economic activity, the bottoming out in commodity prices, and U.S. dollar stabilization. Current spread levels may not offer room for meaningful price appreciation, but the asset class still offers an opportunity to harvest additional yields over government bonds.
Long-term risks in the U.S. corporate credit cycle include high and growing levels of leverage and proposed fiscal stimulus that could spur growth into a narrowing output gap, adding to rising inflationary pressures (see Chart below). Together, these factors could tilt risks toward higher rates, a stronger dollar and a renewed tightening in lending standards.
Fiscal and Monetary Policy Divergence Should Support U.S. Dollar
Proposals from the new U.S. President-elect’s administration suggest a substantial degree of fiscal stimulus over the next two years, and have important implications for the U.S. dollar. Should the U.S. engage in fiscal expansion coupled with monetary tightening, it will diverge from expected policy in the Eurozone, UK and Japan, potentially boosting the U.S. dollar against other Group of Ten (G10)1 currencies.
Risk Focus: Potential for Higher Volatility
We are seeing signs of an inflection point in the global risk environment. A confluence of U.S. fiscal policy uncertainty, an increasingly inflationary backdrop, an extended business cycle, and tighter monetary policy may signal higher volatility across global equities, currencies, interest rates, and credit markets. We are seeing early signs of this in short-dated interest rate volatility, which may reverberate across other asset classes due to the U.S. dollar’s status as a major reserve currency, and could impact everything from global bank funding rates to mortgage rates.
U.S. Election Causes Emerging Market Volatility
Despite relatively cheap valuations, volatility in emerging debt and equity markets has picked up following the U.S. election (see chart). On the other hand, most developed credit (and equity) markets are maintaining a lower volatility profile.
Corporate credit market volatility is somewhat lower and higher inflation may reduce corporate interest expense, improving corporate credit profiles and marginally lowering the risk of their debt. However, judicious selection of credit strategies that can insulate investors from interest rate volatility is important.
We anticipate stabilizing volatility levels for energy sector commodities as they recover from oversupply induced crude oil repricing, and benefit from higher demand and a more carefully managed supply.
Market Focus: Asset Class and Risk Premia Valuations
Valuations for major asset classes have come off of extreme highs versus a few months ago, but continue to be expensive relative to historical norms. U.S. equity valuations remain high after benefitting from positive sentiment following the surprise election of Donald Trump, but other asset classes are no longer trading at extreme valuations.
Considering Risk Premia Valuations
We prefer to evaluate investment opportunities in terms of risk premia instead of asset classes. This method enables us to focus on the risk factors that drive asset class behavior and not the asset classes themselves, which may be highly correlated due to overlapping risks. When considered through a risk premia lens, most major asset classes appear fairly priced today—as they did three months ago (see Chart). This analysis supports modest over- or underweight positions we may take based on other factors such as macroeconomic or risk conditions.
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