My framework for tactical asset allocation is based on business cycle analysis and the documented findings that asset classes tend to exhibit distinct performance in each phase of the business cycle. For example, equities and bonds tend to perform best during the recession phase, credit in recovery phase, and commodities in expansion and recovery phase. By implication, cash is best held during peak phase when all aforementioned asset classes tend to exhibit below average performance.
"My expectation is that the world economy will not enter peak phase until 2020"
Chart 1 illustrates the relationship between asset class performance and the business cycle. One of the key points of the chart is that equity bear markets occur during the peak phase of the cycle, when economic growth is declining but central banks have yet to come to the rescue. Another key point is that equities perform best during the recession phase. This is the phase in which economic growth is negative and when central banks have loosened monetary policy substantially to support economies. In some ways it is counterintuitive that equities perform best during recessions but if you think about it, it makes sense. Equities are forward looking and once monetary policy is loose, they can anticipate economies emerging from recession, even if the recession is still ongoing. Think back to 2009 and you will recall that equity markets performed very strongly during first, second and third quarters of 2009, when global economies were in recession.
The next step is to assess where economies are in the cycle. I do this by considering just a few simple indicators: unemployment, inflation, central bank policy rates, and the yield curve. These in aggregate will give me a good idea of whether economies still require support or are overheating. I can then determine where economies sit on the business cycle and thus what asset class returns to expect.
Given the above chart, I want to be most underweight so-called ‘risky assets’ when we move from expansion to peak, then move fairly rapidly from underweight to overweight as the peak phase progresses.
Our total equity target gives a very good indication of our total exposure to ‘risky assets’ as it will constitute the bulk of the exposure. Thus Chart 2 illustrates how our exposure to risky assets has changed over the last two and a half years and is expected to change over the next 2-3 years.
As you can see, we started reducing equities in mid-2016 as the economic recovery was making, in our opinion, good progress. But we remained overweight equities in relation to our strategic asset allocation until the third quarter of last year and have since moved further underweight.
My expectation is that the world economy will not enter peak phase until 2020, and I intend to continue to reduce our equity targets until then.
A couple of points to note. In the real world, the business cycle is not a neat wave as it is in theory - it is messy and there are times when economies can go backwards rather than forwards. Secondly, the timing of the peak is very hard to estimate – my prediction of early 2020 will almost certainly be wrong. This is why changes in tactical asset allocation should be gradual not sudden. If I am late, I will have reduced to some extent already. If I am early, I can continue reducing. Like driving, you should slow down as you approach a bend rather than when you reach it.
Furthermore, gradual moves keep portfolio turnover low and steady.
As for the yield curve, chart 3 below shows that in the case of the US it has been a very good predictor of equity bear markets (or at worst below average returns). Selling equities when the yield curve inverts, and buying as it becomes steep, would have helped avoid periods of poor equity market performance as well as captured good ones (the yield curve is not a perfect indicator but ‘perfect’ does not exist in financial markets).
Over the last five or so years, the yield curve has been flattening markedly, and a simple extrapolation has it inverting in late 2019. I expect other economies around the world to have exhibited something similar, given the connectedness of the global economy. Thus, by late 2019 I intend our funds to be significantly underweight equities.
Finally, some of you may ask what the business cycle has to do with ‘Multi-Asset Value Investing’, our declared investment style. The answer is ‘everything’. The business cycle informs the monetary policy cycle and the monetary policy cycle tells you whether various asset classes are worth holding in relation to cash. In other words, whether they are over-, under-, or fairly valued. Indeed, relative valuations of equity markets are more important than absolute ones. Markets can appear expensive in absolute terms, as they indeed may have as early as 2014, but if real cash deposit rates are negative, they can keep going up. Only when cash is worth holding will it become a viable alternative to equities and other financial assets. Those central bankers really are worth watching.
Published in Investment Letter, February 2018
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.