Conclusion
As the Fed looks to move its policy toward neutral and beyond, we’ve also moved the overall risk level of our tactical asset allocation recommendations to neutral. This month, we lowered our recommended equity exposure by 3 percent, reducing U.S. equities by 2 percent and adopting a neutral position, while further reducing our emerging markets exposure to a 3 percent underweight. We’ve added the proceeds to investment grade bonds, reflecting our preference for corporate credit over equities and also our view that interest rates are unlikely to move materially higher from here. It is important to look at our recommendations from an overall portfolio perspective. While our high yield overweight is considerable, we view it as a risk asset, and it is the least risky of the risk assets. We think both the fundamental and technical picture for high yield looks attractive, including the current yield-to-worst of 6.5 percent.
In our base case scenario of a Slowdown to Channel Growth, we think corporate credit should perform well. In the recent uptick in market volatility, investment grade credit spreads have not budged and the spreads on high yield bonds are not showing signs of credit stress. In fact, our fixed income desk sees multiple buyers in the market today for every seller of a high yield bond. Our base case scenario of Rising Monetary Policy Disconnect highlights the contrast between the Fed’s plans and the market’s views on growth and financial market risks – which is putting some pressure on risk assets.
We think the upcoming U.S. midterm elections will garner a lot more attention in the media than in the financial markets. The Trump administration’s signature initiatives (tax cuts and regulatory relief) have been done primarily outside of the traditional legislative process. Additionally, investors aren’t expecting any significant legislation out of Congress, so a change in control within Congress in the midterms is unlikely to lead to much of a change in the economic or financial markets outlook. Instead, investors will be better rewarded by paying attention to our risk cases of Emerging Market Contagion and Central Bank Tunnel Vision. The near-term risks for emerging markets have increased in the wake of populist politics, and are complicated by the state of U.S.-China relations. Central Bank Tunnel Vision could lead to unwarranted interest rate hikes, which will bite into growth and financial markets. An uptick in the growth outlook for 2019 and beyond would be just the antidote to this risk case.
Jim McDonald is chief investment strategist at Northern Trust.