Deciding (strategically) how much of your portfolio should on average be invested in equities (vs. cash, debt, gold, etc.) is a most personal decision that should be based on your own risk/return expectations and circumstances (e.g. expected cash outlays). As such, it is one that Butterwire cannot contribute to. The (tactical) decision to deviate from your strategic target from, say 60% to 30% or even 0% equities as recession expectations escalate and materialise, is usually the next most important investment decision. While Butterwire’s core focus is on stock selection and equity portfolio management, the “top-down” insights provided in its markets section were designed to assist investors on making such calls. As a general rule, low and worsening of global growth expectations (iGDP) will ask the question of taking equities’ allocation down over the following weeks, often in favour of safe long-dated government debt (as recessions typically go hand-in-hand with disinflation, which is good for bond returns) but also cash (in strong curren cies) and/or physical gold (the latter two offering the most protection when inflation meets global recession/stagnation). Note however the unique risk presented to eurozone country bondholders, given the impossibility for, say Italy and Germany, to use monetary policy to regulate trade imbalances and in turn the large risk to bondholders if each were to revert to the lira and the deutschmark.

Butterwire’s focus is on getting the most out of whatever portion of your portfolio is allocated to equities, that is, to try and both maximise expected long-term returns and minimise intervention, speculation, and generally the risk of suffering a catastrophic drawdown. But what does Butterwire have to contribute to the question of a portfolio allocation to equities relative to other asset classes? It is a crucial question: an investor who systematically and temporarily moved 100% of its equity portfolio to cash half-way through each of the 10 worst monthly sell-offs of the past 40 years, ended up twice as rich as one who didn’t!

Equities are the ultimate liquid asset to own in periods of positive global growth expectations, and such conditions have historically been present 70% of the time over the past century. However, the shift to the 30% of times when things are not so rosy can be quite sudden and lead to irreparable loss. This would suggest allocating a material, though not extreme, portion of one’s portfolio to equities, but be prepared to reduce (or neutralise, see section 4e) it whenever global growth expectations shift to “downcycle” mode, until the point of maximum pessimism is reached, and a recovery phase is set in motion. Another implication would be to diversify one’s portfolio into regions with higher structural growth potential, ie. North America and Asia ex-Japan, and to keep a portfolio with an above average recession resilience score to try and minimise the odds of large sudden loss.

Besides supportive growth expectations, most of the world’s market capitalisation also thrives in a disinflationary environment (ie. most stocks from consumption and innovation sectors), as this both stimulates consumption and expands valuation multiples. Such an environment has been prevalent since the 1980’s, thanks to deregulations, the collapse of the Soviet Union and the rise of global supply chains and of China. In turn, bouts of inflationary growth do occur that favour more cyclical/value stocks (ie. most stocks from the production and transaction sectors), to the detriment of growth stocks. Finally, the source of growth expectations is another driver of equity return as illustrated by the fact that the Emerging Markets index outperformed the US by 15% pa in the 2000’s, while the US outperformed EM by 13% in the 2010’s.

Therefore as a very general rule:

  • High/Improving global growth expectations (iGDP) would suggest a higher allocation to equities, especially:

    • Investment-driven/Value stocks when growth is accompanied by rising inflation expectations (many Financials, Real Estate, Commodities, and Capital Goods stocks belong in this category, and a high % of EU/EM stocks)
    • Consumption-driven/Growth stocks when growth is disinflationary (many Consumer discretionary and Technology stocks in this category, and a high % of US/Developed Asia stocks)
  • Low/Worsening global growth expectations would suggest a lower allocation to equities in favour of:

    • Long-dated safe government in case of disinflation (safe fixed coupon plus lower yields mean better returns), with residual equity holdings preferably over-represented with:

      • Defensive stocks (many telecoms, utilities, consumer staples and pharmaceuticals stocks in this category) until growth starts to pick up
      • Recovery stocks from when growth expectations bottom out
    • Cash in strong currencies or physical gold in case of stagflation (store of value as other assets, with residual equity holdings preferably over-represented with:

      • Inflation hedge stocks (precious metals plus selected stocks from defensive industries like telecoms, utilities, and staples)
      • Defensive or recovery stocks depending on whether inflation expectations peak and/or growth expectations trough first