Markets are at a crossroads. After a positive start to the year, stocks lost ground as the summer came to an end, dogged by concerns about higher interest rates and the risk of a broader Middle East conflict.
A sharp drop in bond yields over the last couple of weeks has provided a boost, but the outlook is unclear. Having been positive on stocks for most of the year, we turned neutral in the autumn.
Regular readers will know we use an Investment Clock approach to guide our asset allocation decisions. Different asset classes do well at different stages of the business cycle, as defined by trends and turning points in global growth and inflation.
We use a range of indicators to ‘tell the time’ on the clock, with growth indicators determining the up-down direction, impacting cyclical versus defensive positioning, and inflation indicators left-right, impacting what we would describe as asset class duration.
Usually there is a strong macro story that adds conviction to our positioning. Sometimes, however, the indicators are mixed and right now that’s the case both in terms of growth and inflation.
Global growth is sagging but not collapsing. Inflation has come down a long way, but the recent run of data suggests it will be sticky around these levels. The Investment Clock is caught in the crosshairs.
Source: Royal London
At times like this, we are unlikely to take heroic tactical asset allocation positions at the broad asset class level. Rather, we will be watching developments closely to see what new trends start to emerge.
The bull case for stocks from here is technical. Investment sentiment got depressed in October, with our proprietary indicator registering its first contrarian buy signal since the mini-Budget crisis a year earlier (which was a good time to buy). It’s not unusual for volatility to spike in October and it often pays to buy when others are fearful.
Added to this, seasonality is turning positive for stocks. Global equities returned an average 13.8% per annum over calendar years from 1973 to 2022. More than 90% of the total return occurred between the months of October and May.
If you want to throw a handful of macro into the mix, the economy remains relatively robust, Fed rates could be close to peaking, and artificial intelligence underpins a strong earnings outlook and so it’s plausible the US economy experiences a so-called soft landing.
The bear case, meanwhile, appeals to economic history. Spikes in inflation lead to spikes in interest rates which, after long and variable time lags, almost inevitably lead to recession.
Our base case sees the Investment Clock moving into the government bond-friendly reflation phase as global growth softens further and spare capacity weighs down on inflation.
This stage of the cycle tends to be bad for stocks and bad for credit. Macro data could snuff out the usual seasonal rally in stocks. Commodities could go either way, with supply disruption potentially pushing the clock into stagflation, typically the worst configuration for stocks.
While cross asset strategy seems unclear right now, there are trends within asset classes that have been more persistent. We maintain a positive view on the US dollar, with the US economy proving so much more resilient to higher interest rates than European or Asian economies.
The Bank of Japan’s continued loose policy stance has kept the yen weak, to the benefit of Japanese equities, in currency hedged terms. And technology continues to outperform.
Trevor Greetham is head of multi-asset at Royal London Asset Management
