Risk assets need rebalancing as the recovery gathers pace
The business cycle is progressing exceptionally rapidly and over the coming period it will shift from the recovery phase to the mid-cycle phase. This is the opinion of Patrick Moonen, senior strategist at NN Investment Partners.
He explains that this is not necessarily negative for risky assets but that it justifies a more balanced approach – an approach that moves away from exposure to pure cyclical growth towards stable growth.
Moonen said at the start of the year he preferred cycle-sensitive assets in his allocation, which resulted in an overweight in equities and an underweight in government bonds.
âThe prevailing environment at the time fully justified this position. First and foremost, the fiscal response continues to the pandemic crisis. Broad and ambitious economic plans were presented to the United States and the European recovery fund became operational, allocating money for investment projects in member states.
He adds: âSecond, immunization programs have gained ground in Western economies. Normalization of the economy is well underway in the Western Hemisphere. A third factor has been the support of monetary policy, and finally, the corporate side has shown its robustness. Analysts continue to revise earnings estimates upwards. “
Risky assets like stocks, real estate, commodities and high yield bonds all performed very well in this environment. Safe government bonds, on the other hand, posted negative returns.
What’s in store?
With all of this good news announced and widely integrated, the obvious question is: what’s next?
âThe market has become less direct in its preferences,â says Moonen. âThe rise in bond yields has stopped. We have seen a rotation from value stocks to growth stocks, and overall the pace of equity growth has moderated â.
He argues that the environment is changing. Inflation is surprisingly on the rise and the US Federal Reserve has made a hawkish pivot. Profit growth will no longer accelerate.
âOverall, we believe central banks in developed markets will remain accommodative, even in the wake of these rising inflation numbers. They are the result of soaring commodity prices, base effects and supply disruptions, all of which seem temporary to us. The Fed’s hawkish pivot was surprising, but can be interpreted as a way to manage inflation expectations.
Going back to the initial premise that we move from the recovery phase to the mid-cycle phase requiring a more balanced approach (from pure cyclical to stable growth), how is this reflected in asset allocation from NN IP?
âWe reduced downward cyclical risk in our model portfolio during the second quarter. We reduced stocks from a moderate to neutral overweight. On commodities, we reduced our exposure to oil. In the fixed income market, we maintain a moderate underweight position in US Treasuries. Longer term, Treasury yields are on an uptrend, given strong macroeconomic data and the Fed’s likely next steps â.
The risk / return trade-off begins to deteriorate
The markets experienced an unusually strong run, Moonen explains, and the risk / reward trade-off began to deteriorate.
âThe Delta variant, peak earnings and macroeconomic indicators, rising inflation numbers and a hawkish Fed pivot have made the environment more uncertain. On the other hand, the risk premium is close to its lows in the global financial crisis, optimism is high and futures positioning has increased a lot â.
NN IP’s equity allocation remains oriented to take advantage of the dual theme of rising bond yields and rising commodity prices. At the same time, he put more emphasis on secular growth by modernizing health and communication services. From a regional perspective, he entered the third quarter with an overweight to eurozone equities and an underweight to emerging markets.
Nadege Dufosse, head of cross-asset strategy at Candriam, sees things a little differently from Moonen. She believes that we will move from a phase of very rapid mechanical rebound to a phase of more traditional economic recovery.
However, she maintains that we are not near the mid-cycle but the mid-phase of recovery.
âFalling interest rates caused growth styles to outperform in the second quarter. Investors have digested the violent spin in favor of cyclicals and value seen since November 2020. The slowdown in Chinese growth and the rapid rise of the delta variant have probably helped to calm overheating risks. The Fed has also succeeded in reassuring investors that it can adjust its monetary policy â.
So what is Dufosse waiting for for the second semester?
âA resumption of rate hikes, especially real rates. Our style approach is indeed more balanced today, but we will continue to favor non-US equities in this phase and will maintain exposure to value sectors such as the banking sector. A rise in real interest rates generally leads to an outperformance of assets with shorter durations.
She adds: âWe are underweight in bonds and have reduced the duration to enter this new phase of economic recovery. We maintain our exposure to alternative strategies such as equity neutral and systematic strategies. They offer an additional return while diversifying the risk â.
Value versus growth
Kasper Elmgreen, head of equities at Amundi, explains that the rotation of value over growth can be explained by the inflection point of the cycle, reflecting higher growth and inflation expectations.
Since 2000, the dominant secular trend has been one of low growth, disinflation – or low inflation – and even lower bond yields, which has resulted in an extreme fork in the markets.
He argues that the dispersion in valuations between growth and value stocks remains at historically wide levels even after the strong rebound, meaning value has never been so cheap relative to growth.
âThe market value segment generally benefits from an environment of normalizing inflation from low to high as a result of improving macro and micro fundamentals. This is the situation we are in now. Periods of low but rising inflation tend to return pricing power to sectors that have been losing it for years, as happens with the post-covid-19 recovery, favoring the value segment â.
Elmgreen points out that stock performance has a historical link to inflation and the direction of bond yields. “We could move from the current recovery regime to a mid-cycle or expansion regime, which could see yields rise and inflation settle to a higher level than it was before the pandemic.”
He concludes: âSuch a scenario would continue to benefit value stocks, even if the growth momentum slows down. The drivers of this inflection point have not changed, but valuation dispersion remains extreme, giving confidence in the continuation of the rotation. However, such a rotation will not be in a straight line and active stock selection will be key. “
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