There are ample signs of change in the wind for investors. The Federal Reserve is raising short-term interest rates, and U.S. inflation is at target for the first time since 2012. The global trade order that has existed for decades is being disrupted. Several economic indicators are running hot (see Figure 1) even as the current U.S. expansion has begun its tenth year. Volatility is higher as some investors price a dire outcome while others are more sanguine, creating relative value opportunities.

In this midyear update to our outlook, detailed in our paper “Singles and Doubles,” we discuss some medium- to longer-term themes relating to late-cycle investing as well as some shorter-term opportunities arising from current market dynamics.

Asset Allocation Outlook Figure 1: Several economic indicators running hot

Four key themes


We see significant risk of an uptick in inflation, as detailed in our paper, “Inflation Awakening.” We believe investors should understand the inflation sensitivity, or “inflation beta,” of their portfolios. Traditional stocks and bonds tend to respond negatively to inflation surprises (see Figure 2), while real assets not surprisingly tend to respond positively; investors should verify and be comfortable with the inflation betas of their portfolios. In our view, many investors are underexposed to real assets – such as commodities and inflation-linked bonds – and that strategy has generally worked well over the last several years as shocks to risk assets were accompanied by fears of deflation, vastly diminishing the diversification properties of real assets. However, this may not hold true going forward.

Asset Allocation Outlook Figure 2: Commodities, TIPS and REITs tend to be more closely linked to inflation than equities and bonds ex TIPS

Stock-bond correlations

When above-average inflation starts being a bigger risk than below-average inflation, bonds become a less reliable diversifier for equities and other risk assets. To be sure, high-quality bonds remain a crucial component of a portfolio allocation, in our view, because they are likely to be the best-performing assets in a recession. Also, as mentioned above, inflation-linked bonds are attractive before inflation accelerates. However, investors who count on large bond overlays to damp volatility of portfolios of risk assets may be in for some surprises. (See Figure 3. Also, recent PIMCO research focuses on the underlying mechanisms of the stock-bond relationship. For more, read “Treasuries, Stocks and Shocks.”)

Asset Allocation Outlook Figure 3: U.S. stock-bond correlations could shift if inflation climbs


For the last several years, investors have been paid for being long just about any asset (other than commodities) as the exceptional influence of central bank liquidity and lower long-term rates boosted valuations. At this stage in the business cycle, however, with the Fed actively hiking rates and reducing the size of its balance sheet, valuations have become stretched and we should start to see greater dispersion in returns across sectors, regions and factor styles. As is well-known in equity markets, the momentum factor tends to underperform and the quality factor outperform late in the cycle. Similarly, credit spreads tend to underperform equities on a risk-adjusted basis and commodities tend to do well overall as demand starts to outstrip supply. Some of these themes have already begun to play out. Investors should, in our view, stress-test their portfolios at the factor level rather than asset class level to truly understand how it is likely to behave as this cycle plays out. This also underscores the importance of rigorous global research capabilities to pinpoint attractive opportunities in any sector while managing risks. The ability to better analyze the relative value between assets, countries and factors becomes more important than large beta bets.

Asset Allocation Outlook Figure 4: Equities generally outperform credit throughout expansion phase of cycles


Market volatility has been increasing for a number of reasons. To begin with, there is general uncertainty around a possible turn in the cycle. Another reason is the potential for implicit portfolio hedges (such as bond overlays) to become less predictable amid greater inflation risk, leading many investors to de-risk by selling assets and reducing leverage. In addition, the Fed is normalizing policy and perhaps re-striking the put (i.e., reassessing the state of economic downturn that would warrant a shift to easier policy or extraordinary measures). And all this is accompanied by something new: a potential change to the framework for global trade that has been in place for decades. These reasons suggest reducing portfolio volatility either explicitly or implicitly by going up in quality, reducing leverage, raising liquidity or purchasing downside hedges. Many investors avoid these strategies in the belief that they all mean reducing yield and giving up potential returns. However, in light of the uncertainties across many markets, we believe return potential over a two-year horizon will likely be better if these strategies are judiciously employed.

Five investment opportunities

With market dynamics shifting and the potential for greater change ahead, investors may find it difficult to determine optimal portfolio positioning. Here are five investment opportunities we see.

Shorter-maturity bonds

Taking a simplified view, yield curves tend to flatten late in the cycle as the Fed hikes more than expected and then steepen in a recession as the Fed cuts rates. The yield curve has been following this playbook during this Fed hiking cycle, but for a number of reasons we think the flattening is overdone and the risk/reward trade-off favors fading this move.

Asset Allocation Outlook Figure 5: Historical performance of 5s30s swap curve

Three main reasons for the flattening (in addition to late-cycle Fed hiking) are the U.S. Treasury’s decision to stop extending the weighted average maturity of its issuance, the anchoring effect of low long-term global rates, and the ability for U.S. corporations to currently deduct pension contributions at the 2017 tax rate of 39% rather than the new 20% tax rate, leading to a rush to buy long-dated bonds. We feel all of these are likely to reverse as the large U.S. deficit combined with the Fed’s balance sheet unwinding will supply plenty of long bonds to the market, the European Central Bank is expected to end its own quantitative easing program by the end of this year, and the Bank of Japan signals possible flexibility in its pegging of the 10-year rate at 0%. Finally, the window for the higher deduction rate for pension fund contributions ends in September.

“Shorter-term U.S. corporate bonds are offering more attractive yields than they have in years.”

A simpler expression of this trade is to simply invest in shorter-term U.S. corporate bonds, which are offering more attractive yields than they have in years due to a combination of Fed rate hikes, accompanied by wider Libor and credit spreads. Their shorter maturity not only makes them less sensitive to higher rates, but they may also be more defensive in the event of a slowdown or recession.

Basket of EM currencies

Emerging market (EM) assets came off a torrid 2017, but have had a tough run in 2018 as Fed hikes, fears of tariffs and trade conflicts, and political uncertainty in Mexico, Brazil, Turkey and Argentina have weighed on the market. Emerging markets are indeed highly geared to global growth and global trade. Moreover, institutions often aren’t mature enough to handle political change. Any unanticipated slowdown could lead to further underperformance. However, we feel the underperformance is overdone given current risks, and there are pockets of value in EM that rigorous research and an active management approach can uncover. As we discuss in the sidebar, there appears to be an unexplained risk premium associated with EM currencies, which leads us to conclude that a diversified and appropriately sized investment should be part of any long-term asset allocation.


Gold is a real asset that not only serves as a store of value but also a medium of exchange, and that tends to outperform in risk-off episodes. As such, one would expect gold to outperform during the recent period of rising inflation expectations along with rising recession risk. Yet counterintuitively it has been underperforming relative to its historical average (see Figure 6).

Asset Allocation Outlook Figure 6: Gold is trading cheap relative to U.S. real yields

We believe this is because in the near term, gold’s properties as a metal and as a currency are causing it to drop amid trade tensions and the stronger U.S. dollar, dominating its properties as a long-term store of value. This leads, in our view, to an opportunity to add a risk-off hedge to portfolios at an attractive valuation.

Large cap versus small Cap

Small cap stocks have had a good run, outperforming the S&P 500 by close to 5% so far this year. One of the rationales for this outperformance is that small cap stocks are more domestically oriented and hence less exposed to trade wars and tariffs. While this view has some merits, we feel buying lower quality, lower value, higher volatility small cap stocks is unlikely to lead to outperformance should a real trade war commence. Consistent with the theme for high quality to outperform at this stage of the business cycle, and given attractive entry points, we favor an overweight of large cap relative to small cap.

Asset Allocation Outlook Figure 7: Small caps have outperformed S&P 500 this year. Will it last?

Alternative risk premia

Higher volatility and stretched valuations are likely to result in lower risk-adjusted returns from traditional risk premia like equity, duration and credit. While smart beta strategies have been proliferating recently, so far these have mostly focused on equities, an asset class that has been well-mined by academics but where it is still possible to find risk premia and alpha strategies that are uncorrelated to the business cycle.

Meanwhile, there is a rich universe of strategies available in the fixed income and commodity markets that can be combined with equities and currencies to form diversified portfolios that seek to harness the benefits of alternative risk premia. Including diversifying but liquid strategies is important, as many strategies that earn an “illiquidity” premium, such as private equity and venture investing, also have a high beta (correlation) to equity markets, which may not be desirable at the current phase of the business cycle.

“Lofty valuations, an aging expansion and changing rules for global trade are leading to a tricky investment environment.”

Lofty valuations, an aging expansion and changing rules for global trade are leading to a tricky investment environment. While recession indicators are not flashing a red warning signal that a downturn is imminent, which would imply a retreat to a defensive position, they are flashing a yellow “caution” signal. This coupled with expectations for higher volatility suggest a regime of careful portfolio construction and opportunistic investments. In this piece we have highlighted four themes to consider when constructing portfolios and five opportunistic investments across asset classes that we believe will position investors for attractive risk-adjusted returns in the uncertain times ahead.

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Asset class views

Here is how we are positioning asset allocation portfolios in light of our near-term outlook for the global economy and markets.

Asset Allocation Outlook Midyear Update: Overall Dial
Under Over


Overall risk

This late in the cycle, with valuations rich, the Federal Reserve raising interest rates, and the potential for recession in the medium term, we are neutral in our overall positioning. The expansion likely still has some room to run, but there is ample reason for highly selective relative value positioning and rigorous research on securities.

Asset Allocation Outlook Midyear Update: Equities Dial
Under Over





Emerging markets


While we are more constructive on equities relative to other risk assets, in light of the recent rally we are maintaining an underweight to U.S. equities. Given valuations and in view of the late stage expansion, in the U.S. we have an overweight to banks and underweight to small cap stocks. We are modestly overweight Japanese equities given positive earnings, low leverage and still supportive Bank of Japan.

Asset Allocation Outlook Midyear Update: Rates Dial
Under Over





Emerging markets


We remain defensive on interest rate exposure. However, in contrast to our views on equities, we find U.S. rates the most attractive in developed markets. Beyond the U.S., we find U.K. gilts and Japanese government bonds rich, and we believe valuations of eurozone peripheral bonds are suspect without continued ECB support. We favor the front end over long duration Treasuries and have a steepening bias in U.S. rates.

Asset Allocation Outlook Midyear Update: Credit Dial
Under Over



Investment grade

High yield

Emerging markets


At this later stage in the business cycle, investors should appreciate the limited spread-tightening potential of corporate bonds as well as the downside potential for defaults or spread widening. Our credit allocation is focused on non-agency mortgage-backed securities, which should continue to benefit from an ongoing recovery in the U.S. housing market and remain well-insulated from many global risks. Our allocation to investment grade credit is focused on shorter-dated high quality corporates that now offer yields close to 3% without a lot of duration or credit risk.

Asset Allocation Outlook Midyear Update: Real Assets Dial
Under Over


Inflation-linked bonds




Real assets

We maintain an overweight to real assets, with a focus on U.S. Treasury Inflation-Protected Securities (TIPS). Inflation expectations have risen recently, yet we believe there is still value in TIPS as the market is underpricing U.S. inflation risk. While we expect U.S. inflation to rise modestly above the Fed’s target in the near term, longer-term risks remain. We find gold attractively priced as not just an inflation hedge but also a diversifier in the case of a financial crisis.

Asset Allocation Outlook Midyear Update: Currencies Dial
Under Over





EM ex Asia

EM Asia


We continue to favor small tactical positions in some of the higher-carry “commodity currencies” given still-attractive valuations and an embedded risk premium that should benefit long-term investors. Asian economies have benefited inordinately from global trade, but are likely to weaken in the face of slowing Chinese growth.

Investor Summary

Download our Asset Allocation Outlook Summary to learn about key themes impacting major global asset classes.

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