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A Year-End Move Into Less Risky Territory
Our Market Risk Indicator has moved from Normal Risk to Low Risk, prompting us to make adjustments to our US model portfolio.
In response, we have modestly increased and diversified our equity position.
Overall, we continue to hold a slight bias toward defensive assets.
As we move into the first weeks of 2020, the Investment Solutions Group is optimistic that equities and other growth assets can continue to drive ahead, albeit at a slower pace than we experienced in 2019.
From a macro perspective, there are two drivers to our directional overweight to equities. First, after several months in the Normal Risk range, our proprietary Market Risk Indicator (MRI) which looks at global and multi-asset class risk sentiments, has moved to Low Risk aversion. As such, we have adjusted our US model portfolio tactical positions to take advantage of the current market environment.
Secondly, we believe continued central bank support will warrant an overweight in equities. Between the Federal Reserve’s communication that rates are on hold for some time, and the expected expansion of central bank balance sheets to support economic growth, there will be significant liquidity in the system. This will provide a tailwind as we enter the new decade.
Equities allocation
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.
Eurozone outlook
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.
Defensive positioning
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.
Market Risk Indicator (MRI)
A proprietary macro indicator developed by the SSGA Investment Solutions Group. The MRI is designed to identify a level of forward-looking, implied volatility. Factors utilized to generate the signal include implied equity and currency volatility as well as spreads on fixed income.
Purchasing Managers’ Index (PMI) Index
An economic index that reflects the economic status of the manufacturing and service sectors.
Diversification does not ensure a profit or guarantee against loss.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic orpolitical instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.Investing in high yield fixed income securities, otherwise known as "junk bonds", is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Investing in REITs involves certain distinct risks in addition to those risks associated with investing in the real estate industry in general. Equity REITs may be affected by changes in the value of the underlying property owned by the REITs, while mortgage REITs may be affected by the quality of credit extended. REITs are subject to heavy cash flow dependency, default by borrowers and self-liquidation. REITs, especially mortgage REITs, are also subject to interest rate risk (i.e., as interest rates rise, the value of the REIT may decline).
There are risks associated with investing in Real Assets and the Real Assets sector, including real estate, precious metals and natural resources. Investments can be significantly affected by events relating to these industries.
Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations.