Due to popular demand, we are producing a monthly update on our asset allocation views. In our previous report, we outlined our defensive posture of underweight bonds and equities and overweight cash, commodities and crypto. We continue to hold this view. The basis of this view is:
- The Fed will hike even if it means slower US growth.
- We think the odds of a recession are high due to the global energy shock, Fed hikes, falling US real earnings and negative fiscal impulse.
- European growth will be weak on the fall-out from the Russia-Ukraine war, while China’s zero COVID strategy is constraining Chinese domestic demand.
- A structural imbalance in commodity markets will keep commodity prices elevated.
Recent Market Performance
March saw commodities rally by 10%, bonds underperform cash by 1% to 3% and crypto outperform by over 10% (Chart 3). This was in line with our view. Equities, however, performed better than expected, with stocks up 3%. We think this bounce will likely be temporary. Indeed, stocks are still down 5% over the past three months. We examine annualised Sharpe ratios (that is, excess returns adjusted for volatility). Over the past three months, the Sharpe of equities, at around -1.0, has been worse than crypto (bitcoin is almost flat). But DM and EM bonds have had the worst time, with Sharpes between -3.2 and -5.3 (Chart 4).
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Our recession model now assigns a 60% probability of a US recession in the next 12 months. Even Larry Summers has joined us in calling for a US recession. More importantly, we are starting to see signs of weakness in the US economy. Notably, the new orders component of the ISM manufacturing survey has turned down sharply of late. The next shoe to drop will likely be the labour market, so we will be monitoring US jobless claims and the monthly payroll data for signs of weakness.
Our work suggests equities tend to underperform around six months before a US recession. If a recession is coming in 2023H1, it could therefore be too early for equities to underperform. However, we like to stay underweight for now – not least because US stock valuations remain elevated (Chart 2). This increases the fragility of stock returns.
Outside of the US cycle, the global commodity picture continues to look bullish with the risk of European sanctions on Russian energy. This supports our overweight in commodities. The commodity picture keeps upside risks to inflation and so could lead to more central bank hikes around the world, which in turn could dampen growth. Bond yields for now could continue to rise, which suggests staying underweight. As for crypto, adjusted for volatility, they have performed well relative to equities, and our metrics suggest the flow factors for crypto remain positive, so we stay modestly overweight. We keep our overweight in cash – in our last update, we wrote how cash could outperform when markets are fragile.
Finally, in terms of sectors, here are our favourite views:
- Within US, we like to be overweight agriculture, homebuilders, large cap value, reopening trades, semi-conductors, financials, traditional infrastructure and underweight large cap growth and retail.
- Within Europe, we like to be overweight financials and renewables.