The ETF Portfolio Strategist: 18 FEB 2024
Trend Watch: Global Markets & Portfolio Strategy Benchmarks
The year so far is shaping up as a tale of two trends for asset allocation strategies. While aggressive-risk postures continue to set new highs, conservative-oriented portfolios are no longer participating in the rally that started in October.
The diverging trends of late can be seen in the comparison of two asset allocation ETFs. The iShares Aggressive Allocation ETF (AOA) ticked up to another high last week.
Meanwhile, the iShares Conservative Allocation ETF (AOK) edged lower, churning in a trading range that’s well below its previous high point.
Although our Signal score still paints an upbeat profile for all four variations of asset allocation strategies, per the table below, the recent stall in the defensive ETFs is taking a toll on momentum for the more conservative funds. See this summary for details on the metrics in the tables below.
The headwind for AOK is the relatively high allocation to bonds, an asset class that’s been stumbling lately—again. It’s no surprise that conservative strategies tend to underperform aggressive portfolios, but everything has limits in finance and it’s reasonable to wonder if AOA’s return premium has peaked. For some perspective, consider the history of the rolling one-year return spread for AOA less AOK, per the chart below.
Unsurprisingly, the line skews >0 most of the time, which is to say that AOA usually outperforms. But periodically the outperformance fades and AOK adds value relative to its more aggressive counterpart. Those periods usually align with changing perceptions of risk for one reason or another.
Your editor’s intuition tells him we may be approaching one of those periods. The mechanism that would support relatively stronger results in AOA: a recovery in bond prices, driven by lower rates.
That’s not the consensus outlook at the moment, but there’s a case for thinking that a shift in perception is coming as the next phase for the macro trend unfolds. At the core this view holds that the recent weakness in bond prices will stabilize and then transition to a rally. Driving this change is the expected softening in US economic conditions. Although recession risk is still low, and will likely remain so for the near term, the firmer run of economic conditions over the past six months or so appears to be running out of road, at least in terms of accelerating.
As detailed in today’s issue of The US Business Cycle Risk Index, the reacceleration in economic activity since last autumn has probably peaked, based on a set of forward estimates of two proprietary indicators through March. A growth bias is still the prevailing forecast for the near term, at least for now, but deceleration will take the edge off the expansion’s pace in the months ahead.
As this cooling resonates, the case will strengthen for cutting interest rates, which in turn will boost bond prices.
This scenario is still a minority view, but a change, if only on the margins, appears to be brewing from the perspective of the economic trend.
Timing, as always, is unclear. What is obvious is that the bond market is still struggling. The iShares 7-10 Year Treasury Bond ETF (IEF) fell for a second week and is trading near the lowest level of the year.
It’s still too early to favor bonds, but in the weeks and months ahead I expect that the trend will change, per the scenario outlined above. When will bonds pick up on the shift? No one knows, but watching IEF’s trend will likely provide an early clue.
Meanwhile, these are still early days and the case is still uncompelling for lifting bond weights. But change is in the air and I expect that the markets will pick up on the shifting risk profile sooner rather than later.