In late cycle

Multi Asset

In late cycle

At this stage of the cycle, we see a generally risk-friendly environment - and position ourselves for low volatility.

For markets, the key question right now is whether you think we are in a goldilocks or in a late-cycle environment. These two scenarios have very different implications. And they are not that easy to distinguish. Both are characterized by solid GDP growth and low inflation. Both are generally supportive for risky assets. What distinguishes them is how long good times will last, with big implications for asset-class positioning and risk management.

We believe in the late-cycle interpretation. Ever since the global financial crisis of 2008, years of extraordinarily low interest rates and quantitative easing have driven and supported financial returns. We may be close to the turning point in the global policy cycle. There is certainly scope for missteps, as central banks try to escape from their ultra-loose monetary policies. Markets continue to be dependent to a fairly high degree on their every move and whisper.

However, global central banks are expected to remain quite accommodative for the foreseeable future. While they are now one of the main sources of uncertainty, they also continue to stand ready to cushion potential turbulences ahead. We are expecting rates to rise at a modest pace. This should allow the late-cycle environment to continue for another 12 to 24 months. In general, this should support the risk environment and thus asset prices.

Too early to call

Monetary policy aside, there are other concerns, too. In a wide range of asset classes, the current bull market is already relatively long-lived and strong by historic standards. On many measures global equity markets (and other financial assets) are expensive compared to financial history. Moreover, corporate earnings, on which those high multiples are applied, have been boosted by profit margins at record highs (at least in the U.S.).

However, this need not be a cause for immediate concern. Contrary to what many still think, the data on U.S. GDP growth since World War II suggest that economic recoveries do not simply die from old age. This may be one of the reasons why historically, low-volatility regimes have often lasted for quite a long time. The current one could well approach new records, and not just in equity markets. Volatility as a measure of fluctuation of returns and also as a proxy for nervousness in the market has come down to record lows across nearly all asset classes. Meanwhile, daily market moves have narrowed. Arguably, positioning in some areas of the option markets (e.g. betting on even lower volatility and gathering premia) is at rather extreme levels.

Occasional volatility spikes notwithstanding, however, what would drive volatility higher would be the prospect of any recession. Hence we monitor economic as well as sentiment indicators carefully, which continue to look fairly reassuring. Historical analysis suggests a high exposure to equities in such an environment.

We're increasing equity

Taking everything together, we currently see equities as our preferred asset class. Solid earnings growth, healthy balance sheets and still low interest rates suggest further upside potential, despite stretched valuations compared to history. We continue to like Eurozone stocks best, as valuations still leave some room for price increases while the political overhang has been diminished. We also expect emerging-market and Japanese stocks to perform well while we have less conviction in U.S. equities, mainly from a valuation standpoint.

Emerging-market debt remains preferred within fixed income as well as across various asset classes from a risk-adjusted return perspective. To put things into a portfolio context we have reduced risk in developed-market corporate credit, in particular high yield, due to a risk-reward profile that appears to be skewed to the downside, and moved step by step into equities while also holding cash and liquid bonds. Interest-rate sensitivity is comparably low. Gold remains a strategic portfolio component as a hedge against crises. There is certainly no shortage of potential triggers beyond purely economic and financial matters. Geopolitical tensions in North Korea are just one of the non-economic issues we are keeping an eye on.

Equities tend to perform well in late cycle

Equities tend to yield above-average returns in low-volatility periods, which have on average lasted 22 months for the S&P 500.

Relative to equities, high yield looks pricey

In Europe, the yield on high-yield debt is 50 basis points below the equity dividend yield, much lower than the historic average.

Allocation

Raising our equity allocation

We currently see equities as our preferred asset class.

Against a backdrop of solid earnings growth, we are raising our equities allocation. In terms of regional allocations, we continue to like Eurozone stocks and also expect emerging-market and Japanese stocks to perform well, while we have comparatively less conviction in U.S. equities. Especially in the United States, equity valuations appear stretched compared to history, but less so compared to yields available in fixed income. Given tight credit spreads and our expectation of slightly and gradually rising interest rates, we are reducing our allocation for investment-grade bonds and increasing it for emerging-market sovereigns. Gold remains an important diversifier, as part of a slightly reduced overall commodities exposure.

The chart shows how we would currently design a balanced, dollar-denominated portfolio for an Asian investor taking global exposure. This allocation may not be suitable for all investors. Alternatives are not suitable for all clients.

Indicators

The clouds have disappeared!

Indicators point to sunny skies ahead.

During the first several months of 2017, the capital-market environment was fairly favorable. This was also reflected in the signals of the three multi-asset indicators. Towards the middle of the year, things below the surface began to cloud over. This too could clearly be seen in the indicators, which started to diverge. On the one hand, the risk indicator showed a healthy risk appetite among investors. On the other hand, analysts' expectations got a little too far ahead of economic reality, which meant that, in some cases, it was no longer possible to meet or exceed expectations. The surprise indicator therefore slipped into negative territory around the middle of the year.

In the second quarter of 2017, the macro indicator also signaled a temporary deceleration in economic momentum, albeit at a high level. In recent months, the market situation painted by the indicators has brightened up significantly once again. In particular, the surprise sub-indicators for Asia, the United States and Europe have improved, which suggests that things are growing sunnier in all regions at the same time. All three multi-asset indicators are currently in positive territory and point to a risk-friendly investment climate.

Macro indicator

Condenses a wide range of economic data

Risk indicator

Reflects investors’ current level of risk tolerance in financial markets

Surprise indicator

Tracks economic data relative to consensus expectations