Asset Allocation Views: Late‑Cycle Investing

There are ample signs of change in the wind: The Federal Reserve is raising short-term interest rates, and U.S. inflation is at target for the first time since 2012. The global trade order that has existed for decades is being disrupted. Several economic indicators are running hot even as the current U.S. expansion has begun its tenth year. Volatility is higher as some investors price a dire outcome while others are more sanguine, creating relative value opportunities.

All of this is leading to a tricky investment environment. While recession indicators are not flashing a red warning signal that a downturn is imminent, which would imply a retreat to a defensive position, they are flashing a yellow “caution” signal. This together with expectations for higher volatility, market dispersion and inflation risks suggest a regime of careful portfolio construction and opportunistic investments.

For additional details on our latest asset allocation views and the investing ideas we discuss here, please read our midyear update, “Late-Cycle Investing.”

Five portfolio ideas for late-cycle investing
With market dynamics shifting and the potential for greater change ahead, investors may find it difficult to determine optimal portfolio positioning. Here are five investment opportunities we see:
Shorter maturity bonds. We favor shorter-term U.S. corporate bonds, which are offering more attractive yields than they have in years due to a combination of Fed rate hikes, accompanied by wider Libor and credit spreads. Their shorter maturity not only makes them less sensitive to higher interest rates, but they may also be more defensive in the event of a slowdown or recession.

Basket of emerging market currencies. Emerging market (EM) assets have had a tough run in 2018, but we believe their underperformance is overdone given current risks. In particular, we see an unexplained risk premium associated with EM currencies, which leads us to conclude that a diversified and appropriately sized investment should be part of any long-term asset allocation.

Gold. Gold has been underperforming relative to its historical average, likely because in the near term, gold’s properties as a metal and as a currency are causing it to drop amid trade tensions and the stronger U.S. dollar, dominating its properties as a long-term store of value. This leads, in our view, to an opportunity to add a risk-off hedge to portfolios at an attractive valuation.

Large cap equities versus small cap. Consistent with the theme for high quality to outperform at this stage of the business cycle, and given attractive entry points, we favor an overweight of large cap relative to small cap equities.

Alternative risk premia. A rich universe of strategies is available in the fixed income and commodity markets that can be combined with equities and currencies to form diversified portfolios that seek to harness the benefits of alternative risk premia. Including diversifying but liquid strategies is important, as many strategies that earn an “illiquidity” premium, such as private equity and venture investing, also have a high beta (correlation) to equity markets, which may not be desirable at the current phase of the business cycle.

9/11/2018