As the economic expansion aged and volatility increased throughout 2018, consensus shifted from viewing the U.S. expansion as likely to continue for the foreseeable future to believing that we are in the late stages. We believe we are late cycle, not end cycle – a base case outlook driven by our rigorous approach to macroeconomic forecasting. Our key view is that one should continue to be invested, but judiciously prefer securities that are higher in quality and liquidity across asset classes.
Here are key takeaways from our 2019 Asset Allocation Outlook on how we are positioning asset allocation portfolios in light of our outlook for the global economy and markets. In the outlook, we also stress the importance of maintaining “dry powder” in portfolios in order to target idiosyncratic investment opportunities, and we highlight three areas where we are seeing such opportunities today: master limited partnerships, U.K. banks, and China property developers.
Given broadly slowing growth, lower levels of monetary policy support and generally higher levels of volatility, we are maintaining overall risk close to our benchmark, but building liquidity to take advantage of tactical buying opportunities.
We expect volatility and slowing profit growth to continue to impact investor appetite for equities in 2019. Therefore, we have a modest underweight to equities with an emphasis on liquidity and high quality, defensive sectors. We favor large caps over small caps, U.S. equities over European equities and are modestly overweight Japanese equities given positive earnings, low leverage and still supportive Bank of Japan.
We prefer high quality duration as we move toward the later part of the cycle as we still believe that fixed income offers an attractive diversifier for risk in portfolios. However, we are selective in our exposures. We find U.S. rates the most attractive in developed markets. Beyond the U.S., we find U.K. gilts and Japanese government bonds rich, and we believe valuations of eurozone peripheral bonds are suspect without continued ECB support.
Given our late-cycle view, we expect corporate credit will underperform over the coming year. Within corporate credit, we prefer shorter-dated bonds from high quality issuers, especially in defensive and noncyclical sectors, which is in keeping with our quality and liquidity theme. The high yield underweight reflects in particular the glut of low quality leveraged loan issuance. We continue to favor non-agency mortgage-backed securities (MBS) as they remain a relatively stable high quality alternative to corporate credit. We are also keeping dry powder in order to pursue targeted opportunities which we think offer attractive risk/reward characteristics.
In U.S. portfolios, we favor overweighting municipal allocations as U.S. tax reform has created a favorable technical dynamic for the market. Tax law changes have contributed to a drop in issuance while demand has remained steady, particularly in high-tax states where state and local tax deductions were curtailed. Additionally, in this macro environment, municipal bonds may offer investors a late-cycle refuge with attractive, tax-efficient income absent default. However, credit selection will become more critical as economies cool. We continue to emphasize credits backed by dedicated revenue streams less subject to politics and pensions.
Historically, real assets tend to perform well in late-cycle environments; however, that relationship has become less stable in recent periods. That said, we still view real assets as an effective tail risk hedge against rising inflation as well as a portfolio diversifier, and we therefore maintain a modest allocation to what we feel are attractively valued opportunities, including TIPS and MLPs, which should benefit from U.S. production growth.
We have a nuanced view on currencies, and expect more significant alpha opportunities to emerge outside of the majors. We are currently close to neutral in U.S. dollars (USD) versus the other majors, and will pursue idiosyncratic opportunities in emerging markets as they unfold. We expect downward pressures on the Chinese yuan (CNY) to persist, and therefore also maintain Asian currency shorts versus the USD.
For detailed insights into our views across asset classes together with investment ideas, please read our 2019 Asset Allocation Outlook, “Late Cycle vs. End Cycle Investing.”