“This is really helping you to answer the question of whether you want to buy a dip,” Mueller-Glissmann says of the model.
Right now, the team’s research indicates the risk of a stock market drawdown has increased “a bit,” he says, as a result of negative growth momentum and slightly elevated stock valuations. That’s counterbalanced by a positive equity price momentum in the last 12 months, which reflects solid macroeconomic conditions. “These macro conditions usually linger — they don’t disappear overnight,” Mueller-Glissmann says. “A strong positive trend in equities tells you the risk of an imminent bear market is low, because it usually takes time for macro conditions to deteriorate from such a healthy starting point.”
Even more importantly, inflation momentum has been declining for more than a year.
The US Federal Reserve reduced its policy rate in late September by 50 points to 4.75%-5%, showing the central bank is increasingly focused on economic growth, as opposed to stamping out inflation. Policymakers have scope to reduce interest rates to support the economy.
“You can have a correction, but most likely the central bank will step in and buffer the equity market and the economy,” Mueller-Glissmann says. “The Fed put reduces the risk of an equity bear market, though it cannot reduce the risk of an equity correction.”
Mueller-Glissmann’s team is “mildly pro-risk” in portfolio construction for the coming 12 months. Financial markets are “early in the late cycle” of economic growth: unemployment rates are low, profit margins are relatively high, and risk premiums for financial assets are low, for example. “All of those are typical late cycle tendencies,” he says.
Stocks should get some support because consumer and corporate balance sheets are in good shape. The savings rate for European consumers is very high, around 15%, and companies haven’t increased their debt burdens significantly. And while inflation seldom surges early in the economic cycle, that’s exactly what happened following the Covid pandemic amid supply-chain bottlenecks and pent-up demand. That resulted in a jump in interest rates, which prevented a build-up of leverage among consumers and businesses.
“There’s re-leveraging potential left in the private sector that can drive growth,” Mueller-Glissmann says. “When you’re early in a late cycle backdrop, which can last a long time, you want to be modestly pro-risk in your asset allocation, because equities are an asset that can still deliver good returns in these periods.”
Corporate credit, by contrast, can be a more difficult proposition. The extra yield relative to Treasuries is already low, and credit investors are still exposed to recession concerns.
The outlook for the 60-40 portfolio
Many safe-haven assets have already rallied going into the recent dovish Fed meeting. That may make some of them less likely to cushion a portfolio. But even so, Mueller-Glissmann sees scope for US government bonds to provide some buffer to stocks. Economic conditions could be conducive for the traditional 60-40 portfolio, which is split between stocks and Treasury bonds.
“The equity-bond correlation from here should be more negative,” he says. “This is consistent with the market shifting from inflation as a concern towards growth as a concern, and that means there is more benefit of 60-40-type portfolios.”
Source: goldmansachs.com
