Following the winter of our discontent, we saw a solid bounce in economic activity during the second quarter. The Investment Strategy Team (IST) met this week to discuss its weightings and outlook, as we stand on the cusp of the third quarter. We believe growth should moderate from the brisk pace in the second quarter but still produce respectable results. Against this backdrop and giving consideration to recent market actions that seem to be minimizing the influences of March's dramatic leadership shift—when tech and biotech overcorrected, and utilities, REITs, and energy came to the forefront—we maintain our current investment positioning.
We affirm the broad weightings of our model asset allocation strategies.¹ As illustrated in the chart, we remain overweight in equities relative to our benchmarks. We are underweighted in fixed income securities—nominal bonds and cash equivalents combined—and are especially light on core bonds, such as U.S. Treasuries and investment-grade corporate and municipal debt.
Within our domestic equity allocations, we retain overweight positions to both growth stocks and small-cap stocks despite the rough performance these sectors have had since mid-March. In addition, we retain our half-of-benchmark stakes—5% versus 10% in all strategies—in inflation hedges, which include inflation-linked bonds and commodity- and real estate-related securities (such as real estate investment trusts). We feel the underweight in inflation hedges is appropriate, as the recent escalation of major inflation gauges should not cause much harm.
U.S. recovery has legs
We believe the U.S. is currently in the middle of what is likely to be an elongated business cycle with the next recession still well off into the future. The expected Q2 rebound appears to be taking shape along with our growing confidence that the rest of the year will see growth in the 2.5%–2.8% range, just below consensus estimates of 3.1%.
Inflation readings remained well contained but annual rates of change gravitated toward the Federal Reserve's target. Most of the inflation pressures have come from food and energy sources which do not portend extended higher levels of price pressures. Furthermore, excesses that might trip up the economy have not been evident and once-significant systemic risks have largely faded. Against this background, the Fed is removing stimulus support and may be looking to start short-term rate increases next year, but has made clear its willingness to change these tactics in the face of economic struggles. Given the combination of Fed support and no obvious recession triggers, we feel comfortable that the recovery still has several more years to run.
Spanning the globe
Internationally, it appears that major economies in Europe and emerging markets (EM) are at earlier stages of the business cycle. The European Central Bank (ECB) has tried to provide new supports to the banking system through: (1) lower interest rates; (2) negative deposit rates and; (3) new financing vehicles for small businesses, with the idea of stimulating loan growth and avoiding deflation. While helpful, these steps are not a complete solution. We suspect that the ECB will need to take further measures that may include something akin to quantitative easing involving the asset-backed market. Furthermore, resolving issues involving bank capital adequacy and implementing growth-oriented reforms may also be required to help the region expand.
Recent EM performance has been strong relative to the U.S., but it's mostly traded within a broad multi-year range and is getting closer to the top end of this range. Breaking above this range will likely require confirmation of improving economic conditions which has not yet taken place.
Affirming our positions: a time to hold, not fold
While the IST did not make any changes to policy, there was considerable discussion over its current positioning. From an overall perspective, our belief that the expansion still has time to run and that growth will be modest supports the preference for equities in general and growth in particular.
In light of limited follow-through since the dramatic market leadership change that took place several months ago and the fact that markets seem to be reversing portions of this move, we feel that patiently sitting tight is the most prudent course of action for now. In our view, the current outlook bodes well for a return to better performance around stocks that are involved in higher growth parts of the economy.
1 The construction of our model asset allocation strategies generally reflects a combination of asset class valuation and momentum measures, overlaid by the judgment of our Investment Strategy Team. The extent to which—and speed with which—strategy-following client accounts reflect the Investment Strategy Team's models may vary, reflecting client-specific circumstances such as liquidity, tax sensitivity, and investment horizon.
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