Asset allocation views: uncharted territory

Broad market consensus so far is that the global economy is in the midst of a soft landing; however, we remain cautious and alert to potential risks to the downside. The first six months of 2024 have seen a resilient U.S. economy, robust consumer demand, and outperformance from U.S. mega-cap stocks. This has helped to drive U.S. risk assets higher and contributed toward growth—and now interest rate—divergence among developed nations. Against this backdrop, we’re monitoring key opportunities that may present themselves later this year.

1 The U.S. remains the most resilient global market, but opportunities are emerging elsewhere
 

U.S. mega-cap equity outperformance remains dominant and underpins our overweight in equities relative to fixed income at a broad asset class level, but with a focus on asset classes that will benefit from U.S. interest-rate cuts, notably small-cap stocks. Elevated inflation and interest rates have kept small-cap valuations trading well below historical averages relative to U.S. large caps. As a result, small caps are well poised to benefit from a downward move in interest rates.

Geographically, we’re neutral on European equities but improving growth and favorable valuations have us monitoring the view closely. Additionally, we’re seeing signs of stabilization and even improvement from economies that’ve experienced challenges over the past 12 to 24 months. This includes Japan as well as China where policymakers have more recently been amenable to shoring up some of the economy’s challenged sectors, such as property.

2 Divergent views within U.S. investment-grade bonds
 

We have a neutral stance on U.S. government debt and a less favorable outlook on investment-grade credit where we believe spreads aren’t sufficiently compensating investors for potential risk-off market moves. We’re underweight high-yield bonds where the effects of higher short-term rates are just now being felt by issuers, signaling that further volatility is likely. In comparison, leveraged loans have already adjusted to higher short-term rates and we believe offer investors an attractive opportunity. We have an overweight stance in emerging-market debt driven by positive sovereign debt trends and elevated spreads relative to high-yield debt.

3 Private credit and global infrastructure lead our private markets views
 

Public market financing picked up in Q1 in anticipation of U.S. Federal Reserve (Fed) rate cuts following a period of dormancy as market participants waited for more favorable macroeconomic conditions; however, despite this uptick, private credit has remained dominant and continues its growth trajectory, offering investors attractive yields. Direct lending, which constitutes one of the largest segments of the asset class, has generated higher returns than most other comparable asset classes, delivering between 200 and 400 basis points over syndicated leveraged loans over the past decade. Meanwhile, private infrastructure has become one of the fastest-growing asset classes with assets under management growing by over 15% per year for the past 10 years.¹

Among our underweight positions is U.S. real estate where we believe that the worst of the devaluations may be behind us. Easing interest rates will help alleviate pressure within real estate, with recovery likely to take place within Europe first, followed by Canada and then the United States. We remain underweight private equity due to depressed market activity. Higher financing costs continue to constrain banks’ lending activities, while simultaneously adding pressure to private equity valuations. 

Factors to watch going forward

Heading into the second half of the year, we’ll be focused on the pace of disinflation globally as an indicator of the Fed’s ability to move ahead with a rate cut before the end of the year. Developed-market central banks that have started to cut interest rates include Sweden, Canada, and the European Central Bank among others. The Bank of England held its interest rates steady at 5.25% at its June meeting. In the United States, inflationary pressures remained stronger than expected due to idiosyncratic factors over the first half of the year. Our view is that these one-off pressures should come into line by the end of the year, giving the Fed the cover it needs to cut rates, which against a backdrop of stable growth, will be a key catalyst in unlocking relative value in asset classes such as U.S. small caps.

Knowing what to expect from asset classes is essential in building robust portfolios. Read the latest asset allocation views from the Multi-Asset Solutions Team at Manulife Investment Management.

1 Preqin as of 12/31/23.