The divergence between the strength of global risk asset markets against a backdrop of weakening global growth in 2019 has confounded many investors. Asset valuations have climbed to fresh highs since the start of the year, with equities, credit spreads, and rates all performing well overall, despite bouts of market volatility this summer, a decline in corporate profitability, and slumping global investment demand. While slowing economic and profit growth is not usually a recipe for risk asset strength, the slowdown has prompted a swift reversal in global central bank policy, which has boosted asset prices via both lower discount rates as well as expectations of new rounds of quantitative easing. Market expectations for future policy rate hikes across the major G-3 economies have turned into expectations for cuts, and actual cuts in many cases. Real interest rates, or the measure of rates adjusted for inflation, have collapsed.
It is important to note that while aggregate measures of cross-asset returns have shown little reflexivity to the global growth backdrop, under the surface there has been significant differentiation across factors, regions, and sectors, which is masked by some of the broader market ebullience. The macro divergence across the service and manufacturing sectors has played out across equities, with defensive equities outperforming cyclical stocks and quality outperforming value,1 which has aligned with PIMCO’s view at the start of 2019 advocating for high quality and defensive portfolio positioning (see our full-year outlook, “Late Cycle vs. End Cycle Investing”).
With easing now well priced into markets and future growth continuing to appear uncertain, the question investors need to ask is whether accommodative policy can compensate for a slowing, but still growing economy. PIMCO’s base case for the global economy over the next three to five years is for a continuation of lackluster economic growth on average, with low inflation persisting and central banks keeping interest rates at or below New Neutral levels (markets are currently pricing rates well below these). However, there are at least five secular trends with the potential to disrupt the global economy (those factors are detailed in PIMCO’s Secular Outlook, “Dealing With Disruption”).
In the following sections, we share our views across asset classes. We also do a deep dive into two specialized topics: our tactical model for asset allocation that complements our macroeconomic analysis, and our approach to equity investing, which combines balance sheet analysis with insights from style factors and the profit cycle. We hope these two deep dives help explain the ramifications of the dichotomy of well-performing risk assets in a softening growth environment.
While there is a lot of movement beneath the hood (amid specific sectors and market drivers), our high-level view for multi-asset allocation portfolios is little changed from earlier in the year: We are defensively positioned with a modest overweight to high quality duration and an underweight to risk assets. Respecting the state of the business cycle, we maintain a focus on high quality and defensive sectors across stock and bond markets, preferring the U.S. over other developed markets. In light of our expectations of continued dovish central bank policy, we are overweight real assets as well as select emerging markets bonds and currencies. We look to maintain healthy liquidity buffers given our long-term view of stress on financial market structure as evidenced by lower liquidity and increased frequency of “flash crashes.”
Macro modeling asset allocation
To help extract a signal from the noisy and conflicting information from business cycle and financial condition indicators, we employ a robust, systematic framework for tactical asset allocation that complements the discretionary approach based on the macroeconomic analysis PIMCO is known for.
Broadly, our models for asset allocation begin with a set of strategic views anchored in valuations, adjusting for quality and carry. However, asset prices could potentially veer from fundamentals for sustained periods of time, and lead to slow mean-reversion of valuations. We therefore bolster our strategic asset allocation decisions with a set of tactical tilts that rely on systematic variations in asset risk premia over the business cycle.
This systematic framework for tactical asset allocation is based on the empirical observation that macroeconomic conditions tend to evolve in a slow, measured manner. Asset markets, however, tend to underreact in the near term to this persistence in macroeconomic fundamentals (notwithstanding the frantic short-term trading that accompanies significant data releases). As a result, we’ve often found it beneficial to determine tactical asset allocation tilts based on the current state of the macro economy, in anticipation of markets fully pricing in macroeconomic trends.
In order to successfully do this, investors need to take a nuanced approach to teasing out the current state of the economy by identifying an appropriate set of indicators for the health of the global economic cycle. As such, this approach is ideally suited to PIMCO’s investment process, which has relied on analyzing a broad gamut of macroeconomic indicators over the past four decades.
Our tactical asset allocation model examines macro variables grouped into four categories:
Within each category, we include a curated set of variables that together offer a comprehensive view of current macroeconomic conditions across regions. Secondly, we incorporate a systematic view of the impact of shocks to each of these variables on various markets. For example, a positive shock to employment conditions tends to positively affect risk-on factors (like equities or credit spreads), but negatively affect risk-off factors like high quality duration. We believe such an approach provides a robust tactical complement to a value-oriented strategic asset allocation.
How has PIMCO’s tactical model evolved in the recent past?
Through the last quarter of 2018, macro scores for global equities and credit in our tactical asset allocation model deteriorated steadily, driven mainly by a weakening of business cycle conditions. Macro scores then strengthened in early 2019 before becoming more uneven recently (for example, see our model scores for U.S. risk assets in Figure 1).
We also combine our four macro categories into a four-pointed cluster (or “spider web”) graphic that visually charts changes over time – see Figure 2. Since the end of 2018, macro conditions have improved despite deteriorating business cycle conditions of weakening real activity and labor market indicators. These have been offset by softening inflation prints, which support the case for policy easing, as well as indicators of stronger sentiment and looser financial conditions.
On net, combining the information from our four-point cluster of indicators, our tactical asset allocation model is modestly overweight duration and underweight equities and credit spreads in developed markets. On the currency side, the model suggests an underweight position in the U.S. dollar.
We detail our current positioning, which is a combination of the systematic model output as well as discretionary positioning based on macroeconomic and relative value analysis, in our Asset Class Views.
Equity market analysis: pinpointing quality, monitoring signals
For much of the last year we have advocated a defensive, high quality equity portfolio. Our defensive position was a direct output of our empirical analysis of what works in a “growing but slowing” environment and a forecast that the profit growth cycle would slow in 2019. Our analysis currently continues to support a defensive stance, but as in other asset classes, nuances are critical: Subtle signals help us pinpoint alpha opportunities, and assess the likelihood and timing of market shifts that would trigger a change in our investment view.
In this section, we analyze equity markets using three perspectives that help guide our positioning.
Looking at U.S. equities, profit growth has slowed in line with our model forecast (see Figure 3), which currently suggests the weak growth backdrop persists into early next year.
Empirically, our work shows the profit growth cycle is an important input for determining equity portfolio positioning and identifying winners from losers. When profit growth is high (>= +5%) and rising, investors don’t need to pay for it, resulting in a preference for cyclical value (“cheap” stocks). But when growth is slowing, investor preference tends to shift toward growth certainty with increased focus on profitability, and many investors are willing to pay a premium for companies with such characteristics.
When we segment S&P 500 trailing earnings growth into four distinct phases (slowdown, contraction, recovery, and expansion) and evaluate empirical returns, we observe distinct and consistent patterns through time. In a slowing earnings growth environment, while absolute equity market returns are often positive, the strength of returns often deteriorates, becoming lower and more volatile. Historically, we observe a consistent pattern of defensive equity market flows during periods of slowing growth as investors seek to insulate their portfolios from high beta, cyclically exposed market sectors.
By studying historical returns across equity styles, we seek to identify the sectors and styles with the greatest empirical odds of performing well in a given area of the profit cycle (see previous point). During periods when profit growth rates are decelerating, we typically see negative risk-adjusted returns for cyclical groups relative to defensive groups. Furthermore, companies with high quality characteristics (e.g., high profitability) and exposure to the momentum factor typically perform best during periods when profit growth rates are decelerating. Empirically, the value, size, and cyclical factor groups typically don’t generate attractive volatility-adjusted returns until profit growth rates are rising.
Of course, this doesn’t mean there won’t be select opportunities along the way nor does it guarantee the past will perfectly reflect the future, but such analysis helps serve as a roadmap for equity portfolio construction.
Know your country
Analyzing favorable market styles and sectors is important in determining one’s geographic equity allocation. The sectoral composition and quality of institutions can vary meaningfully by region.
For example, when evaluating major equity market regions according to PIMCO’s equity quantitative scoring methodology (see Figure 4), we see that U.S. equities stand out as higher quality, lower risk, higher momentum, and negatively geared toward value. Taking into account what works during slower growth environments (see previous points), it is easier to understand current U.S. equity market outperformance.
When the global economy suffers a manufacturing- and trade-oriented slowdown, non-U.S. equity markets – which generally carry greater cyclical exposure – tend to be more exposed.
Many investors tend to believe U.S. markets are expensive when compared with Europe, Japan, or emerging markets. However, it is important to consider profitability, growth, and volatility differences among regions when making the valuation call. It is true U.S. markets usually trade at slightly higher-than-average absolute valuation levels, based on forward price-to-earnings ratios. However, return on equity (ROE) is also above average and 30%–50% higher relative to other regions in the world, while U.S. earnings growth rates are comparable – and at lower volatility.
Of course as growth momentum bottoms and profit growth becomes more abundant, it will likely call for a shift in equity portfolio composition that takes on increased exposure to cyclicals, value, and non-U.S. exposure. Volatility may become a fixture in equity markets. We think it is early to make a hard rotation to a higher-beta equity portfolio, but remain increasingly focused for a potential turn in growth momentum before we take an aggressive long stance in equities.
The authors thank Mukundan Devarajan and Bill Smith for their significant contributions to the systematic asset allocation and equity market analysis, respectively.