Chief Investment Strategist and Chief Economist
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Even if shocks are avoided, we anticipate slower progress in risk assets going forward.
Developed market (DM) sovereign bond yields spiked upwards and subsequently retrenched again during the month to 22 September 2016. With correlations across most asset markets and regions unusually high, the rise in yields drove declines in assets that we favor as well as those we underweight. However, the driver of the spike in yields – concern that DM central banks would move away from easy monetary policies – appears unfounded to us. We would expect significant relative value differentials in emerging markets (EM) bonds and some US credit assets to reassert themselves. Similarly, the relative value of equities versus DM sovereign bonds is likely to drive a recovery in performance.
Nonetheless, unusual risks abound. The US presidential election could result in significant policy uncertainty both in anticipation of the vote and of the policies enacted thereafter. The transition to a new US president has historically had a costly and under-rated impact on the US and world economy. At the same time, technical aspects of both the Presidential election – i.e. the impact of the Electoral College and Congressional elections – suggests a higher probability of the political status quo continuing than polls of the popular vote suggest.
If election anxiety builds, it could easily give way to a relief-rally if the status quo is indeed maintained. Without substantial evidence of a disruptive regime-change – and one that is not discounted in markets – we would argue that hedging tail risks will be far more beneficial to investors than liquidating core portfolios.
The US is not the only source of political uncertainty. An Italian constitutional referendum looms, as do key leadership votes throughout the continent. Implementation of the UK’s vote the quit the European Union creates additional uncertainty. All of the above suggest diminished policy clarity in developed markets. At the margin, EM policy and political stability has risen, at least relatively speaking.
The stabilization in the US dollar after a historic period of strengthening has also removed a headwind from many EM assets and economies. However, after this year’s rally, EM performance may be subject to setbacks as just witnessed during the DM bond selloff. The recovery in petroleum and other commodities is also likely to be less swift after a substantial rebound. All told, we see somewhat slower progress in risk assets ahead, even if shocks are avoided.
Taking all of this into consideration, the Citi Private Bank Global Investment Committee left its asset allocation unchanged at its September meeting. Our allocation to global equities therefore remains neutral and our allocation to fixed income underweight by 1.0%. We have small tactical overweights in cash and gold. Within our overall fixed income allocation, we have highly distinct overweights and underweights given wide divergences in bond yields across regions and market segments. Over the past year, we have gradually shifted EM weightings above DM weightings after a long period overweight DM.