The late cycle, pro-cyclical rally will persist for this year’s first two quarters until either liquidity starts to deteriorate, inflation materially rises or the synchronized global earnings recovery collapses. Astoria Portfolio Advisors believes that higher dispersion will set in during this year’s second half due to Federal Reserve rate hikes, a decline in liquidity, and a potentially inverted yield curve that will have dramatic portfolio implications.
1. Equities Remain Attractive Until Liquidity Starts to Deteriorate

There has been a tremendous amount of liquidity flowing through the capital markets for several years. Liquidity, along with earnings, have been a key driver for equities. While our in-house quantitative and cross asset research suggests that risk assets remain attractive for the first two quarters, later in 2018, Fed rate hikes, Quantitative Tightening and other Central Banks tempering their QE programs will lead to a decline in liquidity. 
Astoria’s research suggests that a decline in liquidity isn’t priced into risk assets. A decline in liquidity has the potential to create higher dispersion and higher volatility. Astoria likes hedging risk assets by owning liquid alternatives that provide downside protection along with gold and long duration U.S. Treasuries. 
2. Assets that Benefit from Yield Curve Flattening Remain Attractive

2017 saw relentless curve flattening and, in Astoria’s view, there is a high probability for more flattening and even an inversion. Throughout our portfolios, we want to be long assets which benefit from a yield curve flattening and a late cycle economic environment. U.S. energy stocks, U.S. large cap banks, emerging market equities and FX, and European and Japanese stocks all provide investors with a greater margin of safety compared to U.S. equities. 
3. Time to Reallocate to Commodities 

For the past 8 years investors shunned commodities. However, there are numerous signs that inflation is increasing. Given where we are in the cycle, it’s time to begin to allocate to this uncorrelated and under-owned asset class. Moreover, commodities serve as a call option on inflation.
4. Be Very Selective with Fixed Income

Bonds are no longer the risk reduction or high-income generator they were historically. Bonds were a great asset class to own the past few decades. They provided investors with yield, carry, hedging, and diversification. However, investors have poured over $2 trillion into bonds since 2008. Common sense will tell you that when you pour that much money into an asset class over a short time period, all the historical attributes are long gone.
We are particularly cautious on U.S. high yield credit as it is both economically and liquidity sensitive, valuations are rich, and Fed tightening cycles have historically led to credit spreads widening. Astoria thinks the risk/reward in high yield credit is poor and there are a lot more sellers now given the search for yield trade.
Astoria is utilizing municipal bonds, preferred equities, emerging market debt, and senior loans for income. None of these are providing the opportunity they did years ago, but there is a reasonable margin of safety compared to most traditional parts of the bond market.
5. Factors to Consider Now – International Value and Momentum

Astoria likes extracting risk premia in factors and advocates mixing global value, global momentum and global small caps. 
Growth stocks are crowded, expensive, and vulnerable. We prefer owning value stocks given their margin of safety and the difficulty of timing a rotation out of growth. Growth stocks present a major source of funding risk. You clearly see that in U.S. technology stocks anytime the market sells of.
As far as momentum, the U.S. equity market has exhibited momentum for the first 7 years after the credit crisis while the rest of the world finally caught on after Brexit. We prefer to be long momentum in global ex-U.S. equities at this juncture.
6. Buy International Small Caps

While this global earnings cycle accelerates and liquidity is abundant, Astoria thinks it’s prudent to go down the risk curve and invest in global small caps. International small caps are a call option on domestic growth around the world. Compared to large caps, small caps have lower correlations, varying factor, and sector exposures. We would turn bearish when financial conditions deteriorate given the strong linkage between liquidity and small cap stocks.
7. Own the Entire World for Now and Rotate As Dispersion Kicks in

2017 was as good as it gets for global equities. Why? (1) earnings were inflecting higher globally, (2) Central Banks were extremely accommodative and (3) realized inflation was relatively muted. Owning the entire world was the winning strategy for 2017. That will change, however, as liquidity declines and dispersion picks up in 2018. 

John Davi is founder and chief investment officer at Astoria Portfolio Advisors, a New York City firm that builds multi-asset ETF model portfolios using sophisticated cross asset and quantitative research.