Asset Allocation Highlights – A Challenge for Reflation Trading


This is an excerpt from our monthly asset allocation – Points count

Read between dots

The latest dot plot released after the June meeting of the US Federal Open Market Committee (FOMC), showing participants’ assessment of the appropriate future level of the federal funds rate, indicated that 13 of the 18 FOMC members forecast a rate hike at the end of 2023. The median indicated an increase of 50 basis points (bps).

This was more than most market participants expected: They had called for stable rates or only one rate hike by 2023. What was particularly interesting was that the point of 2023 rate has moved, but the forecast for core inflation in 2023 has not.

The Fed’s message seems clear: the central bank is more sensitive and more willing to lean against the risk of too high inflation than are investors.

This revelation posed a challenge to the stimulus trade.

In a sense, however, the market had anticipated that the Fed would eventually conclude that key rate hikes were necessary, but perhaps not quite yet. Expectations for the level of federal funds two years from now had shown two increases of 25bp since early March, when the US Senate passed President Joe Biden’s $ 1.9 billion stimulus package.

Despite the Fed’s subsequent insistence that rate hikes were more distant, market expectations have not wavered.

A relatively mild reaction

The market reaction to the FOMC news has been significant, but some of the initial moves have taken place. On the front end, the current level of the two-year fed funds rate is only 9 bps above its level at the start of April and is consistent with two rate hikes. Further on, real five-year yields surged and five-year break-even points fell, but the two more or less retraced those moves.

However, not everything is back to the way it was before. Very long rates are falling and have continued to fall, with the 30-year nominal rate below 2% at the time of writing, having surpassed 2.40% in mid-May.

US bond yields expected to rise

With the rate rally following the Fed meeting, we saw an opportunity to set up a short position on US Treasury rates. We expect rising yields to be the primary driver of any nominal yield movement and therefore we have also implemented a short sale on US real rates.

Inflation expectations are not far from post-global financial crisis average, while real yields remain close to historic lows despite the looming weakening of the Fed’s quantitative easing (QE) program and the message in points that the FOMC will react to evidence of rising inflation pressure.

Equity reflation transactions

Even as rates rise, we expect continued gains for equities for the remainder of the year, albeit at a slower pace than in the first half of the year. It should be borne in mind that the sustained and continued growth in earnings, combined with more modest price gains, will inevitably reverse some of the price-to-earnings (P / N) expansion that has occurred this past. year.

How strong are the foundations of reflation transactions such as value versus growth given the new interest rate outlook?

We are more confident that cyclical sectors, regions and countries (like emerging markets and Japan) will continue to outperform as the primary driver is global economic recovery as opposed to the level of interest rates.

The relative performance of cyclics has nonetheless been poor in recent months, although this is at least in part due to a lagging automotive sector hampered by semiconductor shortages, while the traditionally larger healthcare sector. defensive outperformed thanks to restored access to non-Covid people. related procedures.

Value stocks have been underperforming growth stocks recently by more than one would expect given that Treasury yields have actually risen slightly. Since June 11, the Russell 1000 Stock Index has fallen 1.7% while growth has gained 4.2%. The value was held back primarily by financials as the market anticipates higher funding costs for banks, but a more hawkish Fed and a reversal in leading indicators also weighed on performance.

The gain for growth stocks, however, was very concentrated in technology in a way that is much more reminiscent of the performance of US stocks before the pandemic, when mega-cap technology made up the bulk of the index’s returns. large. While technology makes up about 50% of the growth index, it has contributed more than two-thirds of recent returns.

We do not yet expect a return to the pre-pandemic equity return model. As longer-term yields rise, value stocks should regain their outperformance. Valuations are still largely in favor of value; the z-score of the relative forward multiple of value over growth is -1.1, which is not much higher than last August’s maximum discount level of -1.4.

The profit outlook remain united. Futures earnings per share (EPS) estimates for growth stocks are already 25% higher than pre-pandemic levels, while for value they are only 4% higher and momentum is good.

Our asset allocation

The market environment is now trying to reflect the timing of the Fed’s cut / tighten as well as the “spike data” theme.

In the midst of a debate over whether the focus should be on the level or marginal change in macroeconomic data, we have seen an out-of-trade spin of reflation after the FOMC, via the outperformance of equities. US via the growth part and a flatter US yield curve.

Revising the Fed’s final rate to levels below 2% raises questions about the steady state of a US economic expansion, with lower potential GDP growth and long-term inflation expectations involved by these levels.

In our opinion, the lax stance of fiscal and monetary policy (notably in the United States) should support risky assets and higher bond yields. Cycle-sensitive assets have the potential to outperform in the second half of 2021.

Growth in other major economies that have been affected by Covid (e.g. Europe and emerging countries outside Asia) is expected to accelerate as vaccinations result in reopenings. Our medium-term scenario continues to favor risk and equities given the fundamentals and the support of economic policy.

We have kept our risk allocation broadly unchanged over the past month at the level of our long-term risk objective. Our net equity the exposure remains overweighted relative to our benchmarks via positions in US stocks, emerging market equities, Chinese equities and Japanese equities against an underweight position in EMU large caps.

Exposure to regional equities seeks to strike a balance between the “growth / quality” and “value / cyclical” styles which helps to hedge against interest rate volatility, while providing a diversified allocation.

Elsewhere, we overweight risky assets such as basic products and Local debt of EM, and we hold other positions to diversify portfolios such as gold.

For a full analysis of our latest asset allocation and positioning in different asset classes, click here

* Please note that this post will take a break for the summer. The next issue will appear in September.

All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different opinions and make different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income from them may go down as well as up and investors may not get their original stake back. Past performance is no guarantee of future returns.

Investing in emerging markets, or in specialized or small sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available. available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds invested in emerging markets may involve higher risk.


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