In times of uncertainty, embrace the only free lunch in investing: diversification

Executive summary

• We expect policy-induced volatility to remain high in the US, but for the country’s fundamental economic resilience to endure
• US equities remain a key part of the strategic asset allocation, despite near term headwinds
• Diversification is key to navigate the uncertainty
• Policy is turning more supportive in Europe adding additional tailwinds to the undergoing cyclical recovery. EU small caps and UK mid-caps offer an attractive relative value proposition, both in relation to their headline peers and to the US
• Sovereign duration remains important for diversification benefits in global multi asset portfolios, alongside offering healthy yields
• Opportunities remain within credit, in particular short-dated investment grade and actively managed pan-European high yield bonds

US tariffs and their impact on the US economy

At the beginning of the year, we expected US growth to normalise towards trend and inflation to gradually move towards the 2% target. However, the Trump administration has moved faster and more aggressively than anticipated in terms of trade and immigration policies. As a result, our outlook has slightly weakened, but we still believe in the underlying resilience of the US economy.

The initial market reaction to tariffs was negative, but this has since reversed as Trump rolled back most tariffs following the turmoil. The market seems to be buying into the idea that tariffs were a negotiating tactic and wouldn’t be long-lasting. In our view, it’s still unclear whether that will be the case. Our base case is that we will see a baseline tariff rate of 10% with some additional sector specific measures. While far off the extremes announced on Liberation Day, this is still a significant increase in trade barriers.

The current budget proposal envisages a significant fiscal loosening with a large package of tax cuts and limited spending cuts. If it goes through, the deficit will widen increasing upside risks to inflation and leading to higher yields across the US curve.

Considering trade, fiscal, and immigration policies, the mix as it stands is inflationary. Whether inflation remains sticky or reaccelerates will depend on the staying power of tariffs and the resilience of the labour market. As a result, the Federal Reserve will likely have to hold rates higher than previously expected due to inflation concerns. However, a more significant labour market downturn may prompt stimulatory cuts.

In terms of risks, we see more upside risks for inflation than downside risks for growth in the near term as well as more unexpected policy induced shocks. These risks could manifest in a temporary reversal of US exceptionalism driving American market outperformance.

What does this mean for asset allocation?

There are challenges of evaluating the market, particularly in the context of the US economic outlook. Earnings estimates revisions are levelling off, suggesting a more measured outlook. However, there are still parts of the market where expectations remain elevated. The sell-off over the last couple of months of has removed some froth from extended valuations, particularly from the tech sector where valuations were particularly stretched. We are taking this opportunity to begin removing equal weighted positions from portfolios, moving back towards market cap weighted indices.

Given the outlook for the US, we favour diversifying equity positioning across regions and the market cap spectrum. Supportive fiscal and monetary policies in Europe should aid cyclical recovery despite trade policy headwinds. Even before recent changes in direction of fiscal policy, we saw relative value in the small and mid-cap space in Europe and the UK respectively due to depressed valuations, low earnings expectation hurdle rates, and relatively less exposure to global trade risks. By tapping into these market segments, we can diversify some of the US specific risks while maintaining our strategic exposure in American equities.

We are also constructive on the ability of fixed income to add significant diversification benefits to portfolios. Sovereign duration remains a key risk anchor to balance out equity risk in portfolios. On the other hand, pockets of investment grade and high yield credit offer a welcome yield pickup whilst corporate balance sheets remain in a healthy state.