Updated: May 18, 2022
In light of my views on the next global downturn as set out in an earlier post, I thought it would also be worth touching on the framework I use for tactical asset allocation. Although valuations of asset classes are important, I believe these need to be considered in relative rather than absolute terms. What I mean by this is that valuations need to be considered in the context of monetary policy, namely real short term interest rates. Business cycle analysis can do this effectively and so is at the core of my tactical asset allocation framework.
"Valuations need to be considered in the context of monetary policy"
The main research that I have drawn on is titled Dynamic Strategic Asset Allocation: Risk and Return across Economic Regimes1 written by Robeco’s Pim van Vliet and David Blitz in October 2008. In it, the authors map real returns of various asset classes to each of the four phases of the business cycle, drawing on data going back to 1948. They found that risky financial assets (equities and credit) perform worst in the peak phase, risky real assets (commodities) perform worst in the recession phase, and, in view of what other asset classes are doing, cash performs worst in the recovery phase. One can therefore vary one’s asset allocation to align it with these findings, as per the graphic below.
As I mentioned in the first section, I think in aggregate the developed world is close to the end of the recovery phase. The analysis above suggests that, given this, we should have been lowering our equity weight from overweight to neutral which is exactly what we have been doing over the last 12 months. From here, the analysis suggests we should be lowering our equity weight further which, again, is what we intend to do.
How severe will the next downturn be? Frankly, I don’t know. Some suggest it will not be nearly as severe as the last one as central banks will prevent it from infecting banking systems. Others suggest that because central banks’ balance sheets are still bloated, and the next downturn will start from lower interest rates, they have less scope to step in.
The good news is that I think I have a decent amount of time to develop my views further in relation to this question.
Published in Investment Letter
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.