Multi asset: rethinking allocations as rates fall

The investment landscape has changed markedly with the reduction in US interest rates, which was part of a wider, global trend. This Q4 issue of Simply put – our three-year anniversary edition – marks the start of the central bank cutting cycle. We consider the significance of this juncture and how much investors will be forced to adapt, innovate and rethink their asset allocation approach.

The CIO’s perspective: the challenges of lower rates

In this special anniversary edition, Simply put quarterly takes stock of the downward trend for interest rates. The Federal Reserve's (Fed) recent decision to lower rates by a hefty 50 basis points (bps) isn't an isolated action. Starting in Switzerland, a wave of rate reductions has swept across the G10 nations, with Japan the notable exception. Potentially, these initial moves are just the beginning.

FIG 1. Central bank rates and market expectations¹

The changing tide may have profound implications for cross asset investment strategies, prompting investors to rethink their approaches to stay ahead in what might become a rapidly evolving situation. The trick is to find the right mix to cushion any shocks. So, what's the best way to diversify in these situations?

Figuring out the best hedges isn't straightforward. It involves a lot of digging and gradual research to pinpoint opportunities that make sense for a portfolio. This is something we've been tackling with our All Roads investment framework. Our approach mixes a risk diversification engine with a drawdown management system (i.e., a risk budgeting engine) and overlays techniques designed to enhance returns and possibly create asymmetry during shocks. This global approach can significantly enhance risk mitigation in a traditional diversified portfolio, especially when the Fed slashes rates.

Our initial takeaway from the onset of rate cuts is: don't rush to sell! Instead, seek out more diversified solutions, and employ dynamic and systematic rebalancing. That's certainly our mantra.

Portfolio positioning: lower rates mean rebalancing

One of the advantages of managing a strategy for 12 years is being able to observe how it has responded to varying conditions. This current situation of declining rates is wrapped in layers of uncertainty: will we see slow or rapid rate cuts, and how profound will a slowdown be?

In the last quarter, we observed a notable increase in risk levels, particularly in early August, when the VIX reached heights not seen since 2020. However, of the six risk premia that make up our traditional exposures, five have currently reverted to normal levels, suggesting an opportune moment for investment. The sole exception remains the duration risk premia, although it, too, is slowly normalising. This general decline is typically a positive indicator for market trajectories, suggesting reduced volatility and potentially steadier conditions ahead – meaning there is no reason to stay away from markets as short rates are slashed.

FIG 2. Risk premia volatilities²

Other signals are less definitive. For example, our trend signal calls for greater diversification, while our Global Risk Appetite Indicator is stuck around neutral. Among our suite of macroeconomic indicators, the growth signal is currently subdued, inflation trends are mixed and the monetary policy signal remains within the ‘dovish’ zone – although it is not deeply entrenched and also shows signs of recovery.

When integrating all available data, our stance is clear: it is not time to exit the market just yet. Rather, we maintain a diversified portfolio to mitigate potential shocks, with key diversification sources currently including bonds and volatility strategies.

Macro: do lower rates mean recession?

Now that the Fed’s rate-cutting cycle has started, what message should investors derive from the move?

Typically, the Fed favours small, incremental rate adjustments of 25 bps. Initial cuts of 50 bps are rare, so they carry significant implications when they do happen. The Fed's recent 50 bps rate cut is fundamentally a response to an altered outlook in its employment scenario – current projections indicate an expected rise in unemployment rates to 4.4% by year-end – and suggests the Fed is bracing for a potential broad downturn in the business cycle.

Despite these concerns, it is important to note that the global growth cycle is not yet deemed dead. Our collection of growth nowcasting signals across eight countries and country zones currently offers a divided message. While the aggregated recession probability stands at 42%, this situation has persisted for nearly a year and could, instead, illustrate a `soft landing’ scenario: a prolonged period marked by near-recession signals without plunging into an actual recession.

FIG 3. Country-level probability of growth nowcasters below the 30% level³

Essentially, the Fed's decision to implement a significant initial rate cut should probably be interpreted as a proactive measure to bolster economic activity and avert a shift from a soft to a hard landing. However, the situation requires ongoing monitoring, particularly the magnitude of future rate cuts – as such adjustments have historically been significant. This warrants close attention from investors and policymakers alike.

Special focus: All Roads versus rate cuts

Now that the case for rate cuts has been articulated, it is important to remember the distinction between minor rate adjustments and a more extensive sequence of cuts, as these do not imply the same macroeconomic and market conditions. We assess the impact on the All Roads strategy of both scenarios by examining how the strategy's composition might evolve and the types of performance achieved under these differing circumstances in the past.

Throughout the life of the strategy, we have navigated through two distinct periods of Fed rate cuts: the 2019 pivot involved minor cuts, while the onset of COVID-19 in 2020 triggered more substantial reductions. The figure below shows how the All Roads portfolio adapted during each period.

FIG 4. Evolution of the asset exposure of All Roads with US Federal Funds Target Rate from 2019 to 2020⁴

Key observations are as follows:

• 2019 rate cuts: The All Roads strategy experienced a significant reduction in market exposure, at about 45%. In particular, there was a 38% drop in duration exposure despite the Fed’s actions. This was partially offset by increased equity exposure, where market trends and risk assessments played crucial roles in shifting the portfolio away from duration and marginally towards selected cyclical risk premia.
• The context in 2020 was markedly different and necessitated a reduction in market exposure for All Roads, which declined by 135% between late February and late April and impacted all risk premia in an effort to control the portfolio drawdown.

So, did our dynamic asset allocation approach allow us to maintain a competitive edge?

• 2019 rate cuts: All Roads performed on par with a 40/60 portfolio during the 2019 rate cuts. However, the S&P Index outperformed by 1.3%. This suggests that smaller rate cuts can lead to outperformance, especially when comparisons are made on a risk-adjusted basis⁵.
• 2020 rate cuts: The larger cuts provide a scenario that highlights the true benefits of a dynamically managed investment strategy. All Roads lost -2.7%, which was less than half of the losses recorded by the S&P Index and the 40/60 portfolio⁵.

These findings underscore the efficacy of dynamic investment strategies, like All Roads, in adapting to various market conditions and rate-cut scenarios, offering a compelling alternative to more traditional passive investment approaches.

Research update: diversification and robustness

As systematic investors, we don’t ‘time’ our research. That said, it is useful to keep an eye on market developments and assess how current research topics fit with the market narrative.

Our research on trend and valuation has found that even during a period when rapidly shifting market trends have caused most trend-following strategies to lag, valuation and trends are natural companions, and this combination seems to offer an appealing power of diversification. Looking more specifically at 2024 offers interesting insights: over the first nine months, trend and valuation displayed a negative correlation of -10%, with the most significant negative correlation (-20%) observed in bonds. This is precisely the type of diversification that is needed amid this ‘slow versus rapid cuts’ line of thinking and has delivered precisely what we aimed for: diversification and robustness in a rapidly changing investment landscape.

In our quest for enhanced diversification and robustness, we recently expanded our set of nowcasting indicators. This is pivotal in enhancing our ability to monitor and respond to the global economic cycle concerning growth, inflation and monetary policy dynamics. Our analysis initially was concentrated on the US, the Eurozone and China, but we have implemented a two-step strategy to incorporate more economies. The first step has successfully integrated countries within the G10, including Canada, the UK, Japan, Australia and Switzerland, and we plan to include the Nordics and New Zealand. The second phase will focus on Emerging Markets, including pivotal economies such as South Africa, India, Indonesia and Brazil.

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Simply put quarterly edition: rethinking allocations as rates fall Download