Where is the Cycle ? What Should My Asset Allocation Look Like ?

Over the last 8-9 years, financial assets have had a good run, but now valuations look stretch and expected real returns are low.

Yet the economic cycle looks supportive for risk assets, with a global economic expansion set to accelerate a bit it seems, plus no inflation, or barely.

For Morgan Stanley’s strategists, history might be able to teach us a thing or too on how to build an asset allocation depending on one’s view of the economic cycle.

Their research report, date November 14 (« Cycle Check-Up : How Will the Bull Market End ? »), is full of interesting comments and charts. We cherry picked some that look particularly useful for investors.

They consider that « a late-cycle environment is usually good for equities. Looking at optimal portfolio allocation over the last 30 years, we find that the best portfolios during ‘expansion’ are equity-heavy (but HY-light), suggesting that a high allocation is still warranted as long as the cycle is intact. »

Source: Morgan Stanley
Source: Morgan Stanley

Actually that’s a pretty cautious statement, because while there are indicators pointing to the pursuit of economic growth worldwide, some wonder if we are not already witnessing some cracks here and there.

Here the historical illustration of how asset allocation has looked like the past 20-30 years and what type of allocation you should expect depending on the phase in the cycle you’re in (Recovery/Expansion/Downturn/Repair).

The report is nevertheless interesting because they tried to look at which leading indicators investors need to look at to anticipate a turn in financial markets.

Source: Morgan Stanley

« For markets, USD strength and corporate credit weakness have been reliable bellwethers for equity tops – commodity/EMFX-USD crosses tend to peak about 7-10 months before S&P 500 peaks, and credit spreads trough 4 months before. For macro markets, focus on manufacturing surveys, durable goods orders and average weekly hours, which lead equity peaks by about 4-6 months. »

Of course the hardship about finding where the current cycle is and how markets might react going forward is in part distorted by central banks, which have greatly help build the current « bubbles » in many asset classes.

Finally, the last table shows how financial assets behave depending the phase of the cycle we’re in.

Source: Morgan Stanley

Currently, according to Morgan Stanley, equities « can still get richer into end-of-cycle », with equity risk premium falling below their current level, which is in line with historical average.

Credit spreads are « close to cyclical troughs – the next le gis wider », and this could be were the nasty surprises might pop-up all of a sudden.

No surprises there, but « bond valuations are extreme », thanks to central banks QE programs.

Also, « volatility typically trends lower in late-cycle… but no this low. »

So when will all this end ? MS refers to the 3 Xs : « eXcessive policy tightening, eXtreme leverage build-up and eXuberant sentiment. »

For the first one it seems so far that central banks are still opting for dovishness, even though the Fed is firmly in the tightening mode, while ECB and BoJ are communicating towards a very gradual « normalization ».

Leverage on the other hand is « high » with a significant increase in private debt to GDP ratio in many regions of the world. So this one seems close to ripe for signalling a possible market correction in the making.

The last one, sentiment, so far looks more « complacent » than « eXuberant ». Yet, some sentiment indicators (flows, % of new highs, put/call ratios) are pointing towards a lot of optimism.

The disconnect with fundamentals so far doesn’t look eXtreme, but it could soon be.

What a bull market does look like ? From a historical perspective, the key characteristics of a bull market are : an average rise of +15% for S&P 500 ; US Dollar up on average (+1.5%) although it declined in 2007 ; realised volatility unusually low.