Easing Into Slowing Growth

Within each category, we include a curated set of variables that together offer a comprehensive view of current macroeconomic conditions across regions. Secondly, we incorporate a systematic view of the impact of shocks to each of these variables on various markets. For example, a positive shock to employment conditions tends to positively affect risk-on factors (like equities or credit spreads), but negatively affect risk-off factors like high quality duration. We believe such an approach provides a robust tactical complement to a value-oriented strategic asset allocation.

How has PIMCO’s tactical model evolved in the recent past?

Through the last quarter of 2018, macro scores for global equities and credit in our tactical asset allocation model deteriorated steadily, driven mainly by a weakening of business cycle conditions. Macro scores then strengthened in early 2019 before becoming more uneven recently (for example, see our model scores for U.S. risk assets in Figure 1).

We also combine our four macro categories into a four-pointed cluster (or “spider web”) graphic that visually charts changes over time – see Figure 2. Since the end of 2018, macro conditions have improved despite deteriorating business cycle conditions of weakening real activity and labor market indicators. These have been offset by softening inflation prints, which support the case for policy easing, as well as indicators of stronger sentiment and looser financial conditions.

On net, combining the information from our four-point cluster of indicators, our tactical asset allocation model is modestly overweight duration and underweight equities and credit spreads in developed markets. On the currency side, the model suggests an underweight position in the U.S. dollar.

We detail our current positioning, which is a combination of the systematic model output as well as discretionary positioning based on macroeconomic and relative value analysis, in our Asset Class Views.

Equity market analysis: pinpointing quality, monitoring signals

For much of the last year we have advocated a defensive, high quality equity portfolio. Our defensive position was a direct output of our empirical analysis of what works in a “growing but slowing” environment and a forecast that the profit growth cycle would slow in 2019. Our analysis currently continues to support a defensive stance, but as in other asset classes, nuances are critical: Subtle signals help us pinpoint alpha opportunities, and assess the likelihood and timing of market shifts that would trigger a change in our investment view.

In this section, we analyze equity markets using three perspectives that help guide our positioning.

Profit signals

Looking at U.S. equities, profit growth has slowed in line with our model forecast (see Figure 3), which currently suggests the weak growth backdrop persists into early next year.

Empirically, our work shows the profit growth cycle is an important input for determining equity portfolio positioning and identifying winners from losers. When profit growth is high (>= +5%) and rising, investors don’t need to pay for it, resulting in a preference for cyclical value (“cheap” stocks). But when growth is slowing, investor preference tends to shift toward growth certainty with increased focus on profitability, and many investors are willing to pay a premium for companies with such characteristics.

When we segment S&P 500 trailing earnings growth into four distinct phases (slowdown, contraction, recovery, and expansion) and evaluate empirical returns, we observe distinct and consistent patterns through time. In a slowing earnings growth environment, while absolute equity market returns are often positive, the strength of returns often deteriorates, becoming lower and more volatile. Historically, we observe a consistent pattern of defensive equity market flows during periods of slowing growth as investors seek to insulate their portfolios from high beta, cyclically exposed market sectors.

Style mapping

By studying historical returns across equity styles, we seek to identify the sectors and styles with the greatest empirical odds of performing well in a given area of the profit cycle (see previous point). During periods when profit growth rates are decelerating, we typically see negative risk-adjusted returns for cyclical groups relative to defensive groups. Furthermore, companies with high quality characteristics (e.g., high profitability) and exposure to the momentum factor typically perform best during periods when profit growth rates are decelerating. Empirically, the value, size, and cyclical factor groups typically don’t generate attractive volatility-adjusted returns until profit growth rates are rising.

Of course, this doesn’t mean there won’t be select opportunities along the way nor does it guarantee the past will perfectly reflect the future, but such analysis helps serve as a roadmap for equity portfolio construction.

Know your country

Analyzing favorable market styles and sectors is important in determining one’s geographic equity allocation. The sectoral composition and quality of institutions can vary meaningfully by region.

For example, when evaluating major equity market regions according to PIMCO’s equity quantitative scoring methodology (see Figure 4), we see that U.S. equities stand out as higher quality, lower risk, higher momentum, and negatively geared toward value. Taking into account what works during slower growth environments (see previous points), it is easier to understand current U.S. equity market outperformance.

When the global economy suffers a manufacturing- and trade-oriented slowdown, non-U.S. equity markets – which generally carry greater cyclical exposure – tend to be more exposed.

Many investors tend to believe U.S. markets are expensive when compared with Europe, Japan, or emerging markets. However, it is important to consider profitability, growth, and volatility differences among regions when making the valuation call. It is true U.S. markets usually trade at slightly higher-than-average absolute valuation levels, based on forward price-to-earnings ratios. However, return on equity (ROE) is also above average and 30%–50% higher relative to other regions in the world, while U.S. earnings growth rates are comparable – and at lower volatility.

Of course as growth momentum bottoms and profit growth becomes more abundant, it will likely call for a shift in equity portfolio composition that takes on increased exposure to cyclicals, value, and non-U.S. exposure. Volatility may become a fixture in equity markets. We think it is early to make a hard rotation to a higher-beta equity portfolio, but remain increasingly focused for a potential turn in growth momentum before we take an aggressive long stance in equities.

Key takeaways

We are in a late cycle environment in which macro conditions are increasingly signaling deterioration, and this fact alone calls for nuanced portfolio construction. However, our macro models suggest that the economic softening so far has been largely offset by central banks around the world pivoting to easing, which has loosened financial conditions considerably. As such, our portfolio positioning remains relatively stable compared with earlier in the year, with a mild risk-off stance.

While we suggest investors consider remaining invested, we highlight important distinctions, and clearly a lot more attention needs to be paid to attributes of each asset in the portfolio. Given the absence of macroeconomic recovery signs so far, we believe quality should be boosted in portfolios even if the factor has outperformed so far this year. We believe the temptation to go down the quality ladder should still be resisted!

Looking forward, it still remains unclear if the loosening of financial conditions will manage to turn the outlook around, and as such we favor portfolios remain liquid. If the macroeconomic momentum were to improve again, emphasis is likely to be via rotations toward more cyclical equities in the portfolio as opposed to large beta changes. In contrast, if macroeconomic momentum continues slowing, we would prepare portfolios for a shallow yet probably long recession.

The authors thank Mukundan Devarajan and Bill Smith for their significant contributions to the systematic asset allocation and equity market analysis, respectively.