In this month’s Core Offerings, we identify five recent macroeconomic developments and highlighting how they impact our current outlook for markets and tactical asset allocation. We also discuss our recent annual investment strategy review and introduce our new proprietary multi-asset risk factor framework, which allows the investment team to better understand the key drivers of risk and return and build more thoughtful, robust investment portfolios.
Key messages in the report:
• Macro-economic events are supporting a modest tilt to equities: Over the past month or so, there have been five key macro developments which support our desire to remain overweight fixed income relative to equities. Global growth and consumer slowdowns are creating a path to rate cuts and adding downward pressure to global bond yields. They support our decision this month to add risk to portfolios via a modest equity overweight, as well as our preference for domestic equities (and closure of our European underweight).
• The world is changing and so is our investment strategy: From the ongoing uncertainty of twin wars, to the return of state-directed industry policy, and the ever-increasing capital being deployed globally to the energy transition and AI, the investment landscape is changing. The implications include higher resting rates for growth, inflation, and interest rates, as well as greater volatility. We believe the astute investor can navigate, and even thrive, in this new world.
• Introducing our proprietary multi-asset risk factor framework: We have implemented an enhanced approach that gives us powerful tools to better understand asset class behaviour and portfolio design. We can now estimate a total multi-asset portfolio’s sensitivity to equity risk or interest rates. This has improved our strategic asset allocation process resulting in modest changes to our allocations and a more customised approach across fixed income.
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 sees 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 geopolitically, 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.
Over the past month or so, there have been five key macro developments which support our desire to remain overweight fixed income relative to equities. These developments also support our decision this month to add risk to portfolios via a modest equity overweight, as well as our preference for domestic equities (and closure of our European equity underweight).
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.
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), suggests 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.
As discussed below, reflecting these developments, we make some changes this month to our shorter term tactical positioning. But first, we discuss our recent annual investment strategy review, and highlight our new proprietary multi-asset risk factor framework.
The world around us is changing significantly, from the ongoing uncertainty of twin wars, to the return of state-directed industry policy and ever-increasing capital being deployed globally to the energy transition and AI. Over the past six months, these forces have been front of mind as we conducted our 2024 review of investment strategy and asset allocation.
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.
The imperative for nations to compete geopolitically, address societal inequities, and fund the energy transition are likely to underpin a higher resting rate for economic growth, inflation, and policy rates going forward.
To briefly summarise our updated secular outlook:
We believe the astute investor can navigate, and even thrive, in this new world. But this will require investors to become more detailed, more active, more creative and more constructive.
Each of these structural shifts are 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:
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 their outwork their investment strategy.
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.
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:
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.
We have introduced a proprietary multi-asset risk factor framework that now underpins our in-house capital market assumptions.
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:
We believe that these changes to our SAAs, alongside the improved analytical tools 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.
Our updated SAAs embody a small upward adjustment to cash weightings, a more customised approach to fixed income across risk profiles, a new Japan equity allocation and a larger allocation to alternatives.
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 to cash position, 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 reemerge, 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 on 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, see us 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 stay 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.
This month we are adding some risk, moving modestly overweight equities…
…however, fixed income remains our preferred asset class for now (see our tactical asset allocation (TAA) positioning on the following page).
Leaning overweight equities as the pathway to lower rates firms
Reassuring US inflation data and firming signs of moderating activity over the month have assuaged market concerns of an inflation breakout that would put rate hikes back on the table, as the resilient US economy is showing more signs of finally responding to tighter policy. We still look for a higher resting rate for growth, inflation, and interest rates, but this should not prevent a modest series of rate cuts in the second half of the year, which would support the economy and markets.
Can policymakers stick the landing? After a fast and steep hiking cycle, central bankers now need to calibrate policy to lower inflation without triggering a recession. There are political and geo-political risks, and the secular inflation outlook is volatile.
Politics takes centre stage in 2024: After the geopolitical shocks of the past two years, politics will be a key market driver this year. More than 64 elections will take place in 2024, headlined by the US in November.
Diverging cycles: The US economy is resilient, but momentum may be peaking, while Europe may be bottoming, and China faces key cyclical and structural challenges. How these macro dynamics play out will be a key driver for markets this year.
Fortune favours the flexible: With ongoing volatility and uncertainty, we believe it pays to be diversified, nimble, and flexible over the year ahead. Investors will benefit from prudently managing liquidity, investing with high quality active managers.
Transitioning towards multi-polarity will likely create more volatility, presenting growth and opportunities for investors. | The trade-off between net-zero commitments, cost and energy security creates a challenging energy transition. | Artificial intelligence presents challenges and opportunities; advances in pharmaceuticals are a constructive force for the long term. | Higher rates increase forward-looking returns across all asset classes, giving investors more options. |
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Source: LGT Crestone Wealth Management. Units refer to the percentage point deviation from strategic asset allocations. Investment grade credit includes Australian listed hybrid securities. Foreign currency exposure is representative of the balanced strategic asset allocation.
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