We have increased our domestic, international, and emerging markets (EM) equities in our US model portfolio, shifting them to an overweight. Our MRI moving to low-risk aversion, combined with improved bottom-up model forecasts for equities drove this decision.
This positive view is not without its risks. Investors have received some geopolitical clarity with the UK elections and the Phase 1 deal on US/China trade. However, broader issues on trade and international relations are not short term in nature and will likely spur periods of volatility in 2020.
US large-cap equities continue to be the largest overweight in the portfolio as we feel this segment offers better upside, given the relative strength of the economy and earnings compared with other regions. We are mindful that relative valuations for US stocks are high compared to history. That said, the combination of low inflation, accommodative monetary policy, and an economy that is supportive of earnings growth will keep capital markets liquid and support asset prices.
European equities are now an overweight in our model portfolio as the region is scoring well across multiple factors. For some time, European equities have offered attractive valuations and dividend yield. What has changed is the improvement of earnings sentiment month-over-month. Third quarter 2019 earnings were marginally better than consensus and likely to continue with fourth quarter reports. While we do not expect massive improvement in the baseline economy, the eurozone is seeing economic support with a potential cyclical upswing in recent data. We recognize that there are still broader structure overhangs to be dealt with in the eurozone. The region needs to contend with what Brexit will actually look like and its impact on the marketplace. Like the US, policy support is positive with the European Central Bank committing to provide continued liquidity. The recent news that the US may refrain from escalating auto tariffs with Europe could also boost sentiment and support the asset class.
Asia Pacific and emerging markets
As part of our add to equities, we have maintained a broad underweight to Asia Pacific equities. Our concerns about sluggish growth and poor earnings sentiment drive this regional position.
We recently brought our EM position back to neutral after several months of underweight. The monetary backdrop that is part of our positive view on equities is a driver for EM. These stocks are at a reasonable valuation relative to developed markets and the expected level of earnings growth. And near-term resolution on trade issues has provided an additional tailwind for the asset class.
Fixed income and other assets
As recession fears have started to subside, the appetite for risk has become incrementally better, denting the outlook for bonds. The lower yields render cash less attractive, while our fixed-income models forecast upward pressure on longer-term yields. Lower inflation expectations and slowing leading economic indicators will steepen the yield curve. We remain positive on credit with an overweight to high-yield bonds. While risk has perked up for CCC rated securities, we are sanguine on overall levels of default risk.
Gold continues to look attractive though in a risk-on environment, we have trimmed some of this exposure in favor of equities. This position offers us positive expected returns as well as a potential hedge to our risk-on positioning.
Real estate investment trusts (REITs) should benefit in the long term from a low interest rate environment. REITs are more insulated from trade concerns but will be challenged by more volatility in interest rates over the coming months. There has been some weakness across the asset class recently due to weakening valuations but the overall positive environment continues.
Given the levels of geopolitical uncertainty, low levels of growth, and a marketplace where investor sentiment could turn quickly, we continue to hold select defensive assets. Overweight positions in REITs and gold play that role in the portfolio. The volatile nature of future trade negotiations and accompanying uncertainty prevent us from eliminating these active positions. These assets will provide a tactical hedge should risk sentiment deteriorate.