We believe there are three reasons for staying with a balanced allocation
Markets cheered softer-than-estimated US inflation and jobs reports on expectation that an end to Fed tightening is near and the economy is headed for a soft-landing. The disinflationary trend is likely to boost real (inflation-adjusted) incomes and consumption, potentially supporting growth longer. This was a key reason why we pushed back US recession expectations to Q1 24. Strong momentum and institutional cash on the side lines could drive the risk asset rally higher in the coming weeks, spurred by the fear of missing out. This is especially so if US Q2 earnings surpass beaten down expectations (consensus estimate: -6.4% y/y). Against this backdrop, it is fair to ask why one should maintain a balanced allocation for investors with a 6-12-month horizon, as opposed to chasing risk assets higher? We believe there are three reasons for staying with a balanced allocation, despite being positive on equity markets near-term.
Tighter real policy rates
The ongoing disinflation is likely to tighten real (inflation-adjusted) policy rates. Measures of US real policy rates, adjusted especially for longer-term inflation expectations, are already above the Fed’s estimated neutral rate (the rate which keeps the economy from overheating). There are also signs that the steep rate hikes of the past year in the US and Europe are starting to impact job markets.
Dwindling excess savings
New estimates from the San Francisco Fed and other independent researchers suggest household excess savings are dwindling fast and could be drained, especially for lower and median income households, by Q4 or early next year, removing a key prop supporting the economy. Moreover, the US Supreme Court’s decision to strike down student debt forgiveness is likely to add a financial burden on c.40m people. Meanwhile, global manufacturing is in outright recession, with new orders contracting. This is also reflected in indicators from key global exporters from Asia.
Resolutely hawkish central banks
Developed Market central banks appear focussed on bringing inflation back towards their 2% target, even at the cost of growth. This suggests policy is likely to remain a headwind for risk assets for the rest of the year, until the Fed and the ECB relent and cut rates.
Against this backdrop, a balanced allocation, highlighted in our CALM strategy, is prudent for investors with a 6-12-month horizon: Capitalise on market opportunities, Allocate broadly, Lean to Asia, Manage volatility.
Tactical opportunity in bonds
Tactically, the risk-reward balance now favours adding to Developed Market government bonds and Asia USD corporate bonds. High-quality bonds are relatively cheap compared with equites, especially in the US and Europe. On technical charts, the US 10-year government bond yield has failed to sustainably break above 4%, marking a key resistance. Long-term yields are unlikely to go much higher even if the Fed hikes another 25-50bps. If anything, slowing growth and disinflationary pressures (including from China) are likely to drag long-term bond yields lower. Hence, they are likely to provide capital gains on top of attractive yields, outperforming cash over the longer run. In contrast, US and Europe equities face derating risks if expectations of a strong earnings rebound in H2 fail to materialise. The S&P500 index, having broken out into a 15-month high, faces the next major resistance at c.4,637, the previous high in March 2022.
Asia ex-Japan equities are inexpensive
At least, they are vs US and European equities. We remain diversified across Asian equity markets. Tactically, we anticipate a new round of policy support at the upcoming China politburo meeting which should revive sentiment towards Asia. Indian equities, after hitting record highs, are due for a short-term correction, but strong earnings should make this a buying opportunity for long-term investors.
Turning short-term bearish on GBP
While rate differentials have driven the GBP higher in recent weeks, the UK faces heightened risk of a recession in H2 as the Bank of England drives rates higher to quell demand and bring inflation back to its 2% target.
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