Navigating risk in a changing world, as the easing cycle comes into view

AN UPDATE FROM LGT CRESTONE’S CHIEF INVESTMENT OFFICE

Since late last year, we’ve held the view that central bank policy rates would be trimmed from mid this year. Markets have vacillated from over-exuberance (and an earlier start to rate cutting) to their recent despair (that lower rates will be a 2025 event). Yet, while the sequence of central banks has likely changed—with Europe to lead instead of the US—recent renewed softer inflation and weak non-US growth now see policy easing coming imminently into view. Reflecting this, we edge tactically overweight equities this month to harvest returns as rates fall. Still, fixed income remains our largest overweight for now. 

We also take the opportunity to discuss our recent annual investment strategy review, in particular, highlighting our new proprietary multi-asset risk factor framework, which now underpins our in-house strategic asset allocation. We also incorporate our belief that the imperative for nations to compete geo-politically, address societal inequities, and fund the energy transition will underpin a higher resting rate for growth, inflation, and rates going forward. This likely fosters more volatility and dispersion. Reflecting this, our new strategic asset allocations embody, among other things, higher allocations to cash and alternatives, a tailored approach to fixed income, and a renewed strategic equity allocation to Japan. 

Five key recent ‘tactical’ developments

Over the past month or so, there have been five key global macro developments which support our desire to remain overweight fixed income relative to equities. They also support our decision this month to add near-term risk to portfolios via a modest equity overweight, as well as our preference for domestic equities (and closure of our European underweight). 

1. US inflation resumed its downward glidepath as growth moderates—Not only did Q1 growth slow to an annualised 1.3% from Q4’s 3.4%, but early Q2 retail sales also flagged a softer consumer. A previously tight jobs market also showed signs of loosening. After a few months of higher-than-expected core inflation prints, April data softened, with ‘above-target’ inflation now isolated to housing services. We expect US rate cuts from September.
2. Europe and UK exit their recessions in Q1—After consecutive quarters of negative growth in H2 2023, the UK and European economies returned to positive growth in Q1 2024. Leading indicators suggest a modest recovery should continue through H2 2024. Easing inflation (on the back of negative growth) and imminent central bank rate cuts (in June for Europe and likely August for the UK) should also support modest growth ahead.
3. Growth in Japan disappoints in early 2024, delaying further tightening—Activity in Q1 fell by an annualised 2.0%, denting optimism regarding Japan’s ability to transition from secular stagnation to nominal growth recovery. While expectations remain upbeat, given rising wages growth and business sentiment, this has likely shifted further tightening in Japan from June/July to October, adding downward pressure to global bond yields. 

Global growth—uneventful outlook? Mild slowing then patchy recovery ahead

4. China hits the panic button over property—Despite stronger-than-expected growth in Q1, signs of a loss momentum through the quarter ultimately culminated in a worse-than-expected set of activity data for China in April. The property downturn, in particular, has deepened. In mid-May China’s authorities responded, announcing significant policies to stabilise the housing sector. At the margin, this is a positive development for Australia.

5. Australia consumer slows ahead of budget stimulus relief—Recent weak retail data, together with anecdotes from retailers and banks (where loan arrears have been rising), suggest that high interest rates are now starting to cause stress for consumers. There are also increasing signs that prior labour hoarding is now giving way to job losses. We expect this to reverse recent inflation pressure, with a start to a modest rate-cutting cycle from Q4. While May’s stimulatory federal budget has likely ensured a delay in the timing of rate cuts, we also expect mid-year stimulus to stabilise the economy through H2 2024 and into 2025.

The world is changing…our investment strategy is also evolving

The world around us is changing significantly. Newspaper headlines from just the last few months highlight the ongoing uncertainty of twin wars in Ukraine and the Middle East and the return of state-directed industrial policy (headlined by the US Inflation Reduction Act and, locally, the Future Made in Australia initiative). These come amid increasingly strained social and political cohesion across many developed nations. We are also seeing increasing sums of money being deployed to the energy transition and generative artificial intelligence (AI). 

We’ve been studying and assessing these trends for some time. We introduced a framework for considering these evolving structural forces and their implications in our October 2023 Observation titled Asset allocation in a changing world. Over the past six months, these forces and their impact on our long-term secular outlook have been front of mind as we conducted our 2024 review of investment strategy and asset allocation.

To briefly summarise our updated secular outlook:

• We are now in a multi-polar world. The uni-polar, US-led international framework that we have known since before the 1990s is giving way to a more complicated backdrop with more diverse actors on the world stage.
• Policy settings are tilting more populist and nationalist. Decades of increasing societal inequity have shifted the median voter away from the conservative libertarian ‘Reagan-Thatcher’ era, while geo-political competition is driving more state-directed industrial policies, undermining ‘comparative advantage’ as the cornerstone of trade.
• The energy transition is picking up pace. The race to net zero is heating up as 2050 draws ever closer. Investment will support jobs, consumer spending and activity.

Investment strategy review—our secular outlook

Each of these structural shifts is likely to be incredibly impactful for the global economy and financial markets in isolation. Taken together, we see complex interactions between them that are likely to intensify their collective impact on the investment environment:

• We see a higher ‘resting rate’ for growth, inflation, and cash rates. Simply put, the imperative for nations to compete geo-politically (including in high-tech areas like AI), to address societal inequities and to fund the energy transition are likely to underpin a higher resting rate for economic growth, inflation, and policy rates going forward, particularly in comparison to the relatively anaemic post-GFC paradigm.
• We see more volatility and dispersion. We are already seeing more geo-political and political volatility as the world transitions away from the more stable post-Cold War era, while the return of state-directed industrial policy will likely mean significant winners and losers will emerge across regions, industries, and individual companies.

While our outlook might appear to paint a troubling picture for portfolios, we believe the astute investor can navigate, and even thrive, in this new world. However, as discussed in our October 2023 Observation, this will require investors to become more detailed, more active, more creative, and more constructive as they outwork their investment strategy.

Introducing our proprietary multi-asset risk factor framework

As part of embedding these four actions across our 2024 investment strategy review, we have introduced a proprietary multi-asset risk factor framework that now underpins our in-house capital market assumptions (i.e., the risk, return and correlation assumptions we make across all our asset and sub-asset classes). This framework traces its roots to the 1970s and builds on a multi-decade journey driven by some of the investment world’s great pioneers, including Markowitz, Sharpe, Treynor, and Fama and French.

The theory rests on several underlying beliefs:

• The behaviour of different asset classes can be explained by a set of underlying factors (such as growth or equity risk), analogous to how different-looking substances, such as diamond and graphite, are composed of the same underlying element, namely carbon.
• Once understood, these factors, or elements, can be used to study how asset classes behave and how they relate to (or correlate with) each other.
• This allows the investment team to better understand the key drivers of risk and return and build more thoughtful, robust investment portfolios.

This approach gives us powerful tools to better understand asset class behaviour and portfolio design. In the first instance, our deeper understanding of risk and return can help us better compare asset classes across a level playing field. For example, if we believe that interest rates have peaked and will fall, we can deliberately calibrate our preferences across asset classes that have a strong exposure to falling interest rates, such as government bonds, credit, or infrastructure.

At a total portfolio level, we can now also estimate a total multi-asset portfolio’s sensitivity to equity risk or interest rates, and better monitor that portfolio’s exposure. This is a key risk management tool employed by some of the most sophisticated institutional investors, including the Future Fund.

A changing world demands a more thoughtful approach to investment strategy

This enhancement to our strategic asset allocation (SAA) process has allowed us to conduct a deep review of the investment strategies across our model risk profiles, which are laid out below and encompass the following improvements:

• Modestly lifting cash allocations. This change reflects the lower opportunity cost for holding slightly higher levels of cash in portfolios, given our expectation for rates to be elevated relative to the post-GFC experience. It also recognises the valuable optionality embedded in cash—it provides investors with liquidity, which they can tap into to access opportunities or more fully take advantage of market dislocations.
• Customising fixed income weights for each risk profile. We believe investors will benefit from customising fixed income allocations within our model risk profiles. For example, more conservative profiles with a larger fixed income allocation will likely benefit from widening their horizon beyond government bonds and quality credit, to more actively managed absolute return or higher yielding credit. Conversely, more aggressive risk profiles, such as growth or endowment, will benefit from the diversifying properties of government bonds relative to their larger equity allocations.
• Refreshing our equity allocations. Our analysis also leads us to further up-weight allocations to global equities to take advantage of a broader market, more exposure to secular growth drivers, such as AI, and the valuable diversifying qualities of foreign currency exposure. While prior strategic allocations centred around a 55%/45% global-to-domestic split, we are lifting that to around 60%/40% across our risk models. As part of this, we are introducing a strategic allocation to Japanese equities.
• Modestly lifting alternatives allocations. This move has been driven by a number of factors, including (1) the diversifying qualities of alternative assets in a total portfolio context, (2) the ability to target secular growth themes, such as the energy transition, digitisation, and supply chain resiliency, and (3) improving liquidity dynamics within private markets, which we wrote about in the May 2024 edition of Core Offerings.
• Applying our total portfolio approach to currency management. Our 2024 SAAs incorporate our total portfolio approach to currency management, which we wrote about in our January 2024 Observation titled Managing currency risk: the benefits of a total portfolio approach. In short, this involves managing currency exposure across a broader set of asset classes (not just global equities, as is typical) to ensure portfolios maximise the diversifying benefits of foreign currency exposure.

We believe that these changes to our SAAs, alongside the improved analytical tools that our proprietary multi-asset risk factor framework gives us, will allow our clients to best adapt to, and take advantage of, the changing investment environment.

Tactically adding risk as rate cuts come into view

For most of the first half of this year, we have communicated a constructive tactical positioning for portfolios. This has been characterised by an underweight position to cash, deployed into an overweight in fixed income. We also retained a neutral exposure to equities to balance, at times, challenging valuations with an expected more supportive outlook embodying lower interest rates and a ‘softish’ economic landing. 

This month we are adding some risk, moving modestly overweight equities. As discussed in our May 2024 Observation: Building better portfolios—An evolution of the 60/40 portfolio, periods of elevated inflation tend also to be periods where equities and fixed income returns are positively correlated. While a renewed outbreak of inflation and shift to further monetary policy tightening could lead to weakness across both traditional asset classes, our greater confidence that inflation and rates are moderating for a time supports modest gains across both. If risks of a hard economic landing were to re-emerge, our overweight to fixed income would also provide some downside protection to portfolios.

 Cash (Underweight -3)—We retain an underweight cash position. We believe cash rates have peaked and returns will moderate as interest rates in Australia are trimmed from Q4. This should provide strong support to fixed income returns, while aiding equities higher (so long as growth doesn’t slow too much). The underweight to cash allows us to harvest what should be a period of positive (modest) returns across both equities and fixed income. 

Fixed income (Overweight +2)—While resilient growth and sticky inflation in the US and Australia have delayed rate cuts until later in 2024, central banks across Europe, the UK and Canada, are trimming rates imminently. With markets sceptical about a cut in Australia before mid-2025, we retain an overweight to local government bonds to capture an earlier start to trimming. Our overweight to credit has continued to perform strongly over recent months, as credit spreads have continued to trend tighter. Renewed tightness and belated signs of macro weakness in the US have led us to trim high-yield credit (from +2 to +1). Despite an expectation that spreads may widen from here, current carry remains attractive.

Equities (Overweight +1)—Falling inflation and policy support, plus only a mild growth slowing, argue against being underweight most markets. Yet, with a ‘soft landing’ largely priced and recent strong returns, there is less support for a large overweight to equities at this juncture. Still, absent a sharp re-acceleration in inflation, any near-term correction in markets is likely to be an opportunity to build positions, rotating from fixed income.

Looking across regions, elevated valuations and concentration risk justify only a neutral stance for US equities, despite strong capex, policy stimulus and thematic drivers associated with the energy transition. The emerging recovery and imminent rate cuts see us close our underweight to European equities. While a rally in China is likely near term, we remain cautious about its sustainability and have stayed neutral emerging markets. We open our new strategic Japan position as a neutral, given recent strong performance and recent concerns about its demand strength. We retain our modest overweight to Australia, reflecting relatively attractive valuations, fiscal and monetary policy easing that buffers the weakening consumer through H2, while the local market should provide some proxy for an improving outlook in China on the back of policy stimulus.

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