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LGT Beacon: Tactical asset allocation for Q4/2018

September 12, 2018

After completing our quarterly asset allocation strategy review, this issue explains LGT Capital Partners' macro and market views, and its investment positioning. All in all, we have decided to reduce the total equity risk of the Princely Strategies to neutral, via measures that result in a shift in favor of US equities and the US dollar.

Over the past few months, the global economic picture has deteriorated slightly: the world economy is still growing at a decent pace, but peak momentum is likely behind us. This has also softened the outlook for inflation, which was never particularly strong in the first place.

  •  In our base scenario, we therefore anticipate a global growth slowdown, generally with only marginally higher inflation rates
  • In our – unlikely – alternative risk scenario, we no longer expect a stagflationary development (i.e. an environment with less growth and more inflation). We now view a normal disinflationary downturn as a more likely outcome (less growth and less inflation). However, we consider a recession unlikely

Although interest rates are on the rise in the US, they have recently receded back somewhat at the long end, while they remain at a relatively low level historically speaking. This signals that markets do not see the risk of an acute, let alone sustained, acceleration of inflation – which is evident in both survey- as well as market-based inflation expectations. Moreover, long-term inflation expectations, such as the five-year/five-year forward breakeven rate, are stable around or near the targeted levels (Graph 2). Admittedly, in some emerging economies, such as Argentina and Turkey, inflation is likely to increase - in the wake of the recent currency depreciations, but the overall outlook remains modest when put into a historical context.

Financial market valuations, with a few exceptions such as the US and Chinese technology sectors or parts of the US bond markets are generally not expensive – and in some cases remain rather low. The rise in corporate debt levels in some sectors offers a precautionary warning, but at the same time is also a typical – and hence normal – feature of economies in their late-cycle stage and is offset by high corporate earnings growth.

The same applies to the comparatively high valuations of US equities. Firstly, these are not very high in absolutely terms. Secondly, they are justified by (very) strong corporate profit growth. However, some regional differences and issues have recently become more apparent. As a result, our constructive fundamental assessment does not anymore automatically lead to a risk-friendly positioning.

Global macro outlook: divergences become visible

While the global economy continues to expand at a decent pace, the synchronous upcycle is probably behind us and the momentum is generally fading (graph 1). The US may once again prove to be the only exception. At least in comparison to the other regions, the US economy could continue to run at full speed, acting as a global growth engine. President Donald Trump's economic policy mix (deregulation, infra-structure investments, business tax reform) is working in that respect. Even the possible political escalation of the so-called trade war has thus far failed to dim the sentiment of American entrepreneurs and consumers, as recent polls and market developments highlight. 

Nevertheless, the global synchronous upswing has started to stutter somewhat (chart 3). Economic growth is cooling off in the eurozone and has lost momentum in Japan (which was recently also hit by natural disasters). Most notably, the outlook for some emerging markets (EM) has deteriorated more markedly following the recent currency markets turbulences.

The partially significant currency devaluations increase the debt burden of EM borrowers, while driving domestic interest rates higher. In China, too, the recent upturn is ebbing away, and the growth rate has returned to its gradual downward trajectory. The trade conflict with the US and stock market losses of more than twenty percent since January are further weighing on the Chinese outlook. The markets have responded accordingly to these globally increasing divergences. Although the bull market remains intact for now, the various potential risk issues have made market participants more uncertain, and increased the markets' news sensitivity.

Five potential risks were reviewed 

In this context, we identified topics that will influence markets in the next three to six months. Three of these we deemed as minor, i.e. they need to be monitored but have only minor or marginal tactical allocation consequences (they may be addressed with the ongoing portfolio management by our various asset class teams):  

  • US midterm elections in November
  • Italian-EU relationship (Quitaly)
  • Approaching British exit from the EU 

However, two topics are potentially more impactful, and required changes in our tactical asset allocation:

  • The ongoing trade conflict, or "trade war" (a term that we deem as overblown at this point)
  • Potential contagion of the emerging market crises

Specifically, we assess these five topics as follows: read on in the attachment by downloading the LGT Beacon

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Note: The next edition of the LGT Beacon is scheduled for mid October 2018.