Aligning Equity Allocations to Inflation’s Changing Trajectory
Many inputs guide multi-asset allocation decisions, but the inflationary shock of the past couple of years has driven extreme volatility and disruption of cross-asset relationships. As the economic and investment climate shifts, tactical asset-allocation decisions may enhance a portfolio’s risk/return profile.
Growth assets, such as equities, have become more appealing as inflation starts to normalize along with more stable policy rates. Corporate earnings growth has likely bottomed in the first quarter; about 78% of the S&P 500 companies reporting so far have beaten estimates, according to FactSet, and many expect to see improving earnings growth in the second half of the year. So, if inflation continues to normalize and a prolonged recession can be avoided, it could help drive a further recovery in equity markets.
We see uniquely attractive characteristics in each of the regional markets, such as the US for its high-quality fundamentals and margins, Europe for its cyclical growth and now China. As the world’s largest emerging market, China is rebounding since lifting its zero-COVID lockdowns. This on its own should bolster global growth prospects going forward.
Adapting Fixed-Income Exposure and Portfolio Diversifiers
After a painful period of rapidly rising interest rates, bond yields may have peaked, making entry points for corporate and sovereign bonds the most appealing they’ve been in years.
We think moderate exposure to short duration (or interest-rate risk) makes sense in this environment. We also favor US Treasuries, which have once again become effective diversifiers to equity exposure as peak policy rates come into view. Wide yield spreads for global corporate high-yield bonds keep them compelling, and we think the emphasis should be on issuers with solid corporate fundamentals, especially in a low-growth world.
Severe underperformance and the lack of a diversification benefit from bonds in 2022 prompted many investors to broaden the field of portfolio diversifiers. Real assets, such as real estate and commodities, as well as cross-sectional currency and equity factor strategies offer potential diversifying return streams. Within equities, given our expectation of a slow-growth, falling-yield environment, we think a tilt toward quality and profitability is warranted. We believe 2022’s US dollar outperformance is likely to unwind during the year while improving economic growth, which bodes well for the euro in the near term.
It’s been a frustrating two years of rising rates and inflation for investors, and the Fed’s stance remains cautiously optimistic. But we think data are consistent with the potential for further normalization in inflation, while sentiment points to some resilience in growth prospects. This will have implications for multi-asset strategies, requiring a dynamic approach that balances adjustments in strategic and tactical positioning.