Citi Private Bank’s Global Investment Committee (GIC) left our tactical asset allocation unchanged this week with Global Equities 8% overweight, Global Fixed Income and Cash 8% underweight.
While positive, US fiscal actions – lent further support by monetary policy comments from US Federal Reserve Chairman Powell – are highly unlikely to match the force of emergency measures during the past two years. COVID variants still cloud the global outlook. However, a rebounding economy should more than offset the decline in macro policy support.
By end 2022, we would expect a moderation in both stimulus and economic growth. As such, forward-looking markets should generate moderating overall equity returns ahead. With our positive but less robust return expectations, we have shifted our allocations within equity markets toward drivers of sustained returns rather than mere recovery from the COVID shock. Such firms with stronger long-term prospects, higher-quality balance sheets, and a strong outlook for future dividend payments should be the way forward.
US inflation has exceeded 5% over the past year. In the coming year, we would expect a US inflation rate of about 3%. As such, US Treasury Inflation Protected securities are among our only high quality fixed income portfolio overweights. While we agree with Fed Chairman Powell that COVID distortions to the economy are not long-term inflation drivers, the Fed’s policy itself should generate somewhat higher trend inflation in the decade ahead. Other Developed Markets central banks are on a roughly similar course.
In the decade past, the inflation-adjusted return on US cash was a cumulative -12%. In the decade ahead, we would expect a 15%-20% real wealth loss for cash and a 10%-15% real loss on investment grade USD fixed income. While future equity returns are also moderating, we would expect a global equity cumulative real return for the decade ahead (including emerging markets) in a range of +30% to +40%.
Rebound in inflation expectations
The delta variant of COVID has set back the world’s battle against the pandemic and dealt a shock to economies with even highly vaccinated populations such as the UK and Israel. However, further vaccinations and economic adaptations are likely to overcome the pandemic headwinds in an uncertain period of time.
A sharp reduction in global COVID cases could alter perceptions of the policy course of central banks including the Fed and ECB. This could catalyze a resumption of “inflation trades” including commodities such as crude oil, while steepening government bond yield curves. This would impact industry group and country-level equity performance over the near-term. A worsening of the pandemic would have the opposite impact (please see our latest CIO bulletin for discussion).
We believe another rebound in inflation expectations – and post-COVID optimism – is probable. However, given the overall state of market recovery and the evolution of macroeconomic policy, we would not dedicate a very large share of portfolios to “COVID recovery” trades. At the same time, while the rally in US growth shares is well supported by EPS gains and low interest rates, the strong market gains of the past two years limit the scope for future returns. A resumption of long-term interest rate pressures could weigh on valuations for the most speculative growth assets.
With a 12-18 month tactical return window, we balance the dueling prospects for sectors to seek the most consistent returns. With a moderation in overall market appreciation, the returns that will accrue from growing dividend payments will stand out more clearly in our view. Firms that pay and grow dividends tend to have stronger-than-average financial stability and have a long-term history of posting smaller declines during equity market swoons. Last month, we allocated 10% of total medium-risk portfolios to dividend growth strategies, split evenly between the US and non-US shares.
We continue to hold a large overweight position in the global healthcare sector to take advantage of its low valuation (among US issues) and persistent revenue and EPS growth. (The US healthcare sector hasn’t posted an annual decline in revenue or EPS since our records begin in the late 1980s). Nonetheless, we are examining concentration risk and always seek to diversify portfolios. Current options are limited by high valuations in most fixed income with our portfolios already overweight credit assets such as variable rate loans.