Asset Allocation Update: Recession Portfolio

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Due to popular demand, we produce a monthly update on our asset allocation outlook. In our previous report, we outlined our defensive stance of underweight bonds and equities and overweight cash, commodities and crypto. We continue to defend this point of view. The basis of this view is:

  • The Fed will rise even if it means slower US growth.
  • We believe the likelihood of a recession is high due to the global energy shock, Fed hikes, falling US real earnings and negative fiscal stimulus.
  • European growth will be weak due to the fallout from the Russian-Ukrainian war, while China’s zero COVID strategy limits Chinese domestic demand.
  • A structural imbalance in commodity markets will keep commodity prices high.

Recent market performance

In March, commodities rebounded 10%, bonds underperformed cash 1%-3%, and cryptocurrencies outperformed more than 10% (Chart 3). This corresponded to our point of view. Stocks performed better than expected, however, with shares up 3%. We believe this rebound will likely be temporary. Indeed, shares are still down 5% over the last three months. We look at annualized Sharpe ratios (i.e. volatility-adjusted excess returns). Over the past three months, the Sharpe for equities, at around -1.0, has been worse than crypto (bitcoin is nearly flat). But DM and EM bonds had the worst times, with Sharpes between -3.2 and -5.3 (Chart 4).

After that ?

Our recession model now assigns a 60% probability of a US recession in the next 12 months. Even Larry Summers has joined us in calling for a recession in the United States. More importantly, we are starting to see signs of weakness in the US economy. In particular, the new orders component of the ISM manufacturing survey has fallen sharply recently. The next shoe to drop will likely be the labor market, so we’ll be watching US jobless claims and monthly payrolls data for signs of weakness.

Our work suggests that equities tend to underperform around six months before a US recession. If a recession is looming in the first half of 2023, it could therefore be too early for equities to underperform. However, we prefer to remain underweight for now, not least because US equity valuations remain elevated (Chart 2). This increases the fragility of stock returns.

Outside of the US cycle, the global commodity situation continues to be bullish with the risk of European sanctions on Russian energy. This supports our overweight in commodities. The commodity chart maintains upside risks to inflation and could therefore lead to more hikes from central banks around the world, which could in turn dampen growth. Bond yields may continue to rise for now, suggesting to remain underweight. As for crypto, adjusted for volatility, it performed well against equities, and our metrics suggest that flow factors for crypto remain positive, so we remain slightly overweight. We maintain our overweight position in cash – in our last update we wrote about how cash can outperform when markets are fragile.

Finally, in terms of sectors, here are our favorite views:

  • In the United States we like to be Overweight agriculture, home builders, large-cap value, reopening trades, semiconductors, finance, traditional infrastructure and underweight large cap growth and retail.
  • In Europe we like to be Overweight finance and renewable energy.

Good luck!

Bilal Hafeez is the CEO and Editor-in-Chief of Macro Hive. He spent over twenty years doing research at major banks – JPMorgan, Deutsche Bank and Nomura, where he held various “global head” positions and researched currencies, rates and cross-markets.
(The commentary in the above article does not constitute an offer or solicitation, or a recommendation to implement or liquidate any investment or to engage in any other transaction. It should not be relied upon as the basis for any decision investment or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)

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