Asset Allocation Viewpoints & Positioning Q4 2021
2022: A Year of Diminishing Liquidity and Slowing Growth
We reduced our overweight to equities in the middle of December in our multi asset portfolios and further increase our exposure to quality/defensiveness as we believe the balance of risks for markets have become less favorable. As a reminder, we have been increasing the quality of our equity holdings since June of 2021 following the Fed’s initial hawkish pivot. While our longer-term business cycle regime model still points to a “Low-Risk Expansion” in the developed world (U.S., Europe and Japan) as growth levels are strong, our shorter-term growth cycle model has recently entered a quad 4 slowdown in the U.S.
Our concern for equities centers around the liquidity cycle. As the Fed intends to drain liquidity in an attempt to tighten financial conditions, multiples should compress. We think this will persist through the first half of 2022 as inflation remains elevated. Further concerning is the fact that the Fed is beginning to tighten financial conditions into a growth slowdown that is already underway.
Within equities, we reduce the U.S. and move emerging markets (EM) to overweight after remaining underweight EM for the last 12 months. EM valuation is attractive, the PBOC is now easing, and our China growth cycle model has transitioned to quad 1 recovery.
Our equity risk premia model, which values equities relative to interest rates, forecasts low teens returns over the next 12 months for the S&P 500 after the recent pull back. We therefore plan to add on weakness.
We have increased our forecast for the 10-year UST yield to ~2.0% by the end of 2022 driven by a higher terminal rate assumption given labor market tightness. As bonds have sold off recently, given market expectations for the Omicron variant to effectively end the pandemic, we have added to duration and reduced our underweight.
We still believe interest rates will rise a bit more driven primarily by real rates as breakeven inflation expectations come down during the tightening cycle.
We maintain our moderate underweight to credit and U.S. high yield as we do not view further spread tightening as likely from here. We think carry remains the primary source of return for the asset class with U.S. high yield priced to deliver low single digit returns above duration matched treasuries.
Sources: Source: MAST, Bloomberg L.P.; data as of December 31, 2021
Inflation has been significantly higher than most market participants and Federal Reserve members expected heading into this year. Even Fed Chair Powell effectively retired the use of the term “transitory” in response to the high levels of inflation that have persisted. Continued unexpectedly elevated inflation could pose a material risk for markets in 2022 and beyond as investors digest the ripple effects of higher prices on consumers, corporations, policy makers, and capital markets overall. As everyone waits to see where steady state inflation settles later this year, the risk is that it remains above 3.0%, and the even greater risk is that it remains significantly above 3.0%. We find this highly unlikely as credit growth has plummeted recently – and bond markets agree as they price inflation of ~3.0% in 2023.
We’re currently in the middle of a massive spike in COVID infections due to the widely reported Omicron variant. Our base case at this point is that the Omicron variant is less dangerous than prior variants, but far more transmissible – and we therefore believe risk assets should be resilient to continued headlines of high case counts. There are two main COVID risks to note in the backdrop of this base case: additional future variants with unknown potential impacts, and a risk of shutdowns even in the context of a less dangerous variant. The former risk is a known unknown, and the latter is something very difficult to underwrite but a potentially meaningful risk to overall economic activity. We consider future shutdowns extremely unlikely, but this remains a risk.
If the Fed chooses to tighten financial conditions in excess of what markets believe the economy can handle, we could see increased volatility and potential downside in markets as rates are trading at relatively elevated valuations and all other assets will respond to increased rate market volatility.
Democrats have signaled a desire to raise corporate, personal and dividend/capital gains tax rates; there has even been discussion of implementing a new wealth tax. These actions would be fiscally restrictive, all else equal, and a higher corporate tax rate would affect the value ascribed to U.S. equities. Additionally, we’ve seen continued political commentary regarding Big Tech, alleged price gouging, and other broader regulatory issues which could contribute to volatility in certain industries in 2022. An unexpected result in the 2022 mid-term elections is another headline risk to watch out for in 2022.
China and Russia Geopolitical Risks
Commentary from Xi Jinping regarding Taiwan and Vladimir Putin regarding the Ukraine has been alarming. An invasion on either account is not out of the question, although we think an invasion of Ukraine by Russia is more likely than Taiwan by China. This type of geopolitical risk could be unsettling towards markets particularly as Russia is a key supplier of natural gas and oil to Europe.
Legal Notices and Disclosures
The views expressed herein are those of the Harbor Multi Asset Solutions Team at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. These views are not necessarily those of the Harbor Investment Team and should not be construed as such. The information provided is for informational purposes only.
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All investments are subject to market risk, including the possible loss of principal. Stock prices can fall because of weakness in the broad market, a particular industry, or specific holdings. Bonds may decline in response to rising interest rates, a credit rating downgrade or failure of the issue to make timely payments of interest or principal. International investments can be riskier than U.S. investments due to the adverse affects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets.
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Harbor MAST BCI Index Sources: Harbor MAST, Bloomberg, Institute of Supply Management, Federal Reserve, Bureau of Labor Statistics, Commodity Research Bureau, National Federation of Independent Business (NFIB), Caixin, European Commission, Japan Machine Tool Builder’s Association, Association of American Railroads, American Iron and Steel Institute, Department of Labor, Conference Board, University of Michigan, Redbook Research, National Association of Homebuilders, Mortgage Bankers Association
Harbor MAST BCI and Rate of Change Index Sources: Harbor MAST, Bloomberg, Institute of Supply Management, Federal Reserve, Bureau of Labor Statistics, Commodity Research Bureau, National Federation of Independent Business (NFIB), Caixin, European Commission, Japan Machine Tool Builder’s Association, Association of American Railroads, American Iron and Steel Institute, Department of Labor, Conference Board, University of Michigan, Redbook Research, National Association of Homebuilders, Mortgage Bankers Association
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