A never-ending late cycle

Multi Asset

At times there is a very fine line between audacity and recklessness in asset management. An investor who puts the pedal to the metal is considered courageous while the investor who eases off the gas too soon may be accused of throwing away returns. We take a middle line, aware that politics and the economy are always good for surprises. In concrete terms, that means hedging your bets against tail risks – even at some cost to absolute returns. And reading the road ahead well is important. At present, a still apparently straight economic road invites speed – but some dangerous political bends mean the right foot needs to stay close to the brake pedal.

The economic and corporate numbers are frankly good, arguing for an aggressive, cyclical portfolio. We assume the global economy will grow by roughly 4% both this year and next. Corporations are reporting good results, funding conditions are still supportive and credit default rates are still staying at a low level. But an array of political warning signs line the road. The greatest danger at the moment is that the trade dispute initiated by President Trump could become a full-blown trade war. What distinguishes this risk from others is the degree of specificity. The trade dispute is already beginning to affect some companies' bottom line, and an even larger number of companies are warning of possible fallout. In the absence of further policy twists, this could still be manageable. The problem, however, is that Trump has demonstrated just how strong-willed he can be on issues that have been bothering him for years – such as his perception that other countries' trade policies have been unfair to the United States. On top of that, domestic resistance to his policies is weakening. The "full-blown trade war" could therefore morph from tail risk to main risk – not only for the countries in Trump's crosshairs but also for U.S. companies and members of the House and Senate facing November midterm elections. We are expecting a stormy autumn.

Other issues, such as record-high debt and central banks shortening their balance sheets, are well known. Let's tackle the topic from a different angle. Under what capital-market conditions would we adhere to our cautiously optimistic investment style? We believe the three most important markers are: 10-year U.S. Treasuryyields should not rise to over 3.5% before year-end; the dollar should not strengthen to the extent that it puts additional pressure on emerging markets; and the oil price should stabilize at no more than $80 to $90 per barrel.

If all three conditions are met, we will remain true to our strategy of buying market dips and focusing on investments that offer the potential for higher returns with acceptable risks. For equities, that means a stronger weighting in the United States and emerging markets versus Japan and Europe. One factor that still favors the United States is the high percentage of tech stocks that are still experiencing a bull market. Equities of Asian emerging markets have become more interesting after the recent correction. We still like emerging-market bonds, primarily those denominated in hard currency. In the industrialized countries we are sticking to investment-grade corporate bonds and continue to give a lower weighting to high-yield bonds. We are underweight government bonds, but they do offer protection during more turbulent periods in the market; in them we prefer the short end of the yield curve. We also believe that gold and the yen are opportune instruments for some timely diversification. Since we are in the late phase of the business cycle, we think some commodities may be suitable to address rising demand and rising inflation expectations. For European investors, we think U.S. investments have lost some of their appeal compared to last year. But the strong dollar depreciation at the beginning of the year suggests to us that hedging the dollar against the euro, which has become expensive anyway, seems no longer necessary. At its current level, we do not expect the dollar to make a major move for the time being.

Dollar-denominated emerging-market bonds have suffered this year, and their yields are now in line with local-currency bonds.

Source: Thomson Reuters Datastream as of 7/4/18

A 2-year dollar hedge costs 750 basis points for Europeans. As we expect the dollar to trade sideways, it seems unnecessary.

Sources: Bloomberg Finance L.P., Thomson Reuters Datastream as of 7/4/18

Allocation

The economic backdrop remains mostly robust, despite unrelenting political risk. We believe it is still the right environment to buy the dips for the time being and to remain invested in the more cyclical market segments. For equities, our favorite asset class, we prefer the United States and Asian emerging markets to Europe and Japan. For bonds, we think the most interesting opportunities are also in the emerging markets, although we are becoming more selective. We are reducing our exposure to dollar and euro corporate bonds and turning more to floaters. For diversification purposes, we continue to hold short-dated government bonds from industrialized countries as well as gold and yen in the portfolio.

Source: Multi Asset Group, Deutsche Asset Management Investment GmbH as of 6/25/18

The asset allocation shown here represents a balanced model portfolio denominated in euros. It is not necessarily suitable for all investors and is subject to change without notice. Alternative investments are exposed to various risks, are not suitable for all investors, and are not available for every portfolio.

Indicators

Compared to 2017, the DWS indicators have been all over the map this year, mirroring investors' emotional rollercoaster ride between bullish economic data and political risks. The DWS surprise indicator is a prime example of this ambivalence. It has been yo-yoing between positive and negative territory recently despite the fact that, at the global level, most data releases have beaten consensus expectations. Positive surprises predominated in the United States, Europe was a disappointment and the biggest fluctuations were in Asia. Currently, the indicator points to a slightly positive environment overall.

The picture is similar for investors' risk tolerance. The correction in equity markets at the end of January saw the DWS risk indicator plummet to its lowest level since the beginning of 2016. It recovered briefly, but the latest turmoil in emerging markets has pushed the indicator into risk-averse territory. The DWS macro indicator has held steady this year. Despite a brief bout of weakness, it is pointing to a still positive macroeconomic environment. At the moment, two of the three DWS indicators are in positive territory. Despite a robust macro environment, investor sentiment is fluctuating considerably.

Condenses a wide range of economic data

Source: Deutsche Asset Management Investment GmbH as of 6/21/18

Reflects investors’ current level of risk tolerance in the financial markets

Source: Deutsche Asset Management Investment GmbH as of 6/21/18

Tracks economic data relative to consensus expectations

Source: Deutsche Asset Management Investment GmbH as of 6/21/18