Asset allocation implications of the macro backdrop

The most topical theme for debate in the last few weeks has been central bank activism. Many investors and commentators have argued that there is a weaker case for unconventional monetary policy stimulus now compared to previous episodes of quantitative easing in 2008 and 2010. After all, during those two episodes, break even inflation rates were at much lower levels than they are now, indicating that investors are not currently worried about deflation. Others have also noted that the direction of economic data has taken an upward turn recently. However, in my view, these arguments miss the broader picture.

While day-to-day economic data can be volatile and inconclusive, the underlying trend in global economic growth has been clear for some time. Data shows that the current pace of global growth is the softest recorded since the recovery began in 2009.

This decline in the pace of growth has been pervasive. In the eurozone, the periphery remains in recession and the core is experiencing a sharp slowdown which may well turn into outright recession in the months ahead. The UK is in recession – albeit a relatively mild one – the Chinese slowdown is proving deeper and more protracted than previously anticipated, and the US economy has slowed to a stall. It is in this broader context that the recent spate of central bank actions must be assessed.

History shows that the sensitivity of economic activity to negative shocks varies across the economic cycle. At this juncture, central bankers are mindful that the current phase of the global economic cycle represents a window of vulnerability. This means that the developed market economies will do well to avoid a major negative shock over the next few months. Arguably, any such negative shock would represent a sufficient, if not necessary, condition for renewed recessions across the major developed economies.

Unfortunately, there is no shortage of potential sources of negative shocks in the next few months. Besides the risks of another flare up in the eurozone crisis, a prominent source of concern is the unresolved political risk in the US that may culminate in the ‘fiscal cliff’— a combination of tax hikes and deep government spending cuts in 2013.

While the jury is still out on the impact that central banks’ stimulus programmes will ultimately have on real economic activity, their impact on financial markets has been more apparent. In particular, recent decisions by the European Central Bank and the US Federal Reserve have boosted investor sentiment and resulted in sharp rallies in risk assets despite the relatively weak economic backdrop.

Within the fixed income asset class, we continue to prefer selected investment grade corporate bonds to government bonds. Nevertheless, government bonds of the major developed economies continue to offer relative safety and liquidity which makes them attractive to many investors in these uncertain times. Equities trade at attractive yields both relative to inflation and relative to yields on government bonds. In our view, this makes equities the preferred asset class for long term investors.

However, it is noteworthy that the recent gains in equities have resulted in a rapid rise in bullish sentiment among investors. Additionally, implied volatility on the S&P 500 index – the VIX index – has now fallen to multi-year lows. Low readings in this index have typically been associated with short term weakness in equity markets. Overall, concerns about the short term outlook for equities temper the more positive messages from an assessment of relative valuations.