By Mid-September, our Risk Allocation Index has again weakened, although it is still in Neutral territory. As a result, we maintain a neutral risk allocation between Hedge and Risk assets but have – again – lifted our Cash position to an overweight.
The investment climate is now changing in several ways: I. The US Output Gap has closed. Risk assets have historically performed weaker when this has occurred. II. The GDP cycle has moved phase from Solid Uptrend to Early Downtrend. Although this shift is typically not dramatic for risk asset performance, it signals a late-stage business cycle where a solid downturn could be next. III. Central banks are currently prolonging a positive Liquidity cycle that has, in terms of phases for liquidity, shifted back into ‘Easy Credit’ from ‘Tighter Credit’. Again, this is typically positive for risk asset performance. IV. Last but very importantly, the inflation cycle continues to run negative for risk asset performance. The latter is our leading cause for concern.
Is higher inflation transitory or more permanent? With US inflation readings above 4% y/y, there is in our view a clear transitory element in the current inflation picture. Second-round effects from rental and labor inflation could keep inflation above 3% for longer. If that shows to be the case, 10Y could, in our view, start convergence towards fair value, which currently is close to 2.65%.
In our Hedge portfolio, we have cut our position in long US Gov. bonds from Neutral to UW because of the weaker Risk/Reward. Our Hedge portfolio holdings of EU Gov. bonds are still in UW. Both IG (EUR) and Risk-Off FX stay Neutral. In this sub-portfolio, we have – again – raised our holding of Cash from Neural to OW.
In our Risk portfolio, we maintain OW in our Core Equities portfolio and EU equities. We are again moving Japanese Equities back into Neutral from UW as the market appears relatively attractive to, e.g., US equities. US equities are still kept in a Neutral position.
A special note should be made about China’s current influence on Emerging Debt and Equities. Uncertainty about China’s regulatory overhaul of the domestic corporate sector and the potential default of Evergrande are both factors that add to the already weak return expectations for these two asset classes. Therefore, are both kept in UW.