Markets & Economy

Asset Allocation Keeps Powder Dry With Shift Toward Bonds

February 10, 2017
Equity valuations do not reflect downside risks to the U.S. economy, prompting a modest shift in favor of bonds over stocks.

Key Points

  • While U.S. economic fundamentals are improving, the T. Rowe Price Asset Allocation Committee moved to modestly overweight bonds relative to stocks for the first time since 2000.
  • Combined with already low unemployment and stabilizing oil prices, the Trump administration’s plans to cut taxes and increase infrastructure spending suggest that the macroeconomic environment has more room to improve.
  • However, current equity valuations appear to be pricing in a best-case growth scenario without adequately accounting for downside risks.
  • Stocks are a critical component of investors’ portfolios, and they are strategically important in our asset allocation portfolios. We will continue to make tactical moves as market dynamics shift.

The maxim to “keep your powder dry” goes back more than 200 years to British military and political leader Oliver Cromwell and refers to the practice of maintaining a ready supply of dry gunpowder under challenging battlefield conditions “to be able to fire away at the proper time.”

In the investment world, dry powder typically refers to a defensive portfolio of cash and liquid bonds that can easily be shifted toward riskier assets when opportunities arise. At our most recent Asset Allocation Committee meeting, we decided to add dry powder to our multi-asset portfolios. The decision meant that, for the first time since 2000, as we stare down the barrel of an eight-year bull market in stocks, we moved to underweight stocks relative to bonds.

While it is not a decision that we take lightly, the move represents a modest tactical shift. We continue to believe that stocks play a critical role in driving returns in diversified portfolios. Without a significant strategic allocation to stocks, investors may not achieve their long-term retirement goals. Moreover, bonds—the main alternative to stocks—currently appear expensive. In this context, the purpose of this special Asset Allocation perspective is to explain the Asset Allocation Committee’s decision and to expound on why we think the stock market isn’t pricing in enough downside risks.

Fundamentals Are Improving...

We recognize that U.S. economic fundamentals are improving. Although the recent market rally has been attributed to the Republican sweep of Congress and the White House and President Trump’s pro-growth policies, corporate earnings were already starting to improve before the November elections. U.S. earnings growth turned positive on a year-over-year basis in the third quarter of 2016, ending the so-called earnings recession of five consecutive negative quarters. Moreover, the prior earnings recession was concentrated in the energy and materials sectors, which were hit hard by tumbling prices for oil and other commodities, while a strong dollar added to the challenge. After adjusting for energy and currency effects, we estimate that earnings for the S&P 500 Index grew in the double digits in 2015 and in the mid-single digits in 2016 compared with flat (0%) unadjusted earnings growth for both years.

Combined with already low unemployment and stabilizing oil prices, the Trump administration’s plans to cut taxes and increase infrastructure spending suggest that the macroeconomic environment has more room to improve. Among Trump’s pro-growth policies, tax cuts potentially will have the most direct impact on corporate earnings. U.S. gross domestic product (GDP) grew 1.9% (versus 2.2% estimates) in the fourth quarter of 2016 on an annualized basis; CEO confidence among corporate management has risen to its highest level since 2011;1 and a recent estimate of the U.S. purchasing managers' index, a measure of U.S. manufacturing and services activity,2 indicated expansion.


However, we worry that the market is priced for perfection. Our Asset Allocation Committee monitors a wide range of valuation measures of markets around the world and across asset classes, as well as other fundamental and macroeconomic conditions and market behavior. As a simple illustration of how stocks are richly valued, the exhibit below shows a long history of the Shiller price-to-earnings (P/E) ratio for the S&P 500 Index. This ratio normalizes earnings on a rolling 10-year basis and adjusts for inflation. On January 27, 2017, the Shiller P/E ratio stood at 28, near historical highs (with the exception of the tech bubble), and was perilously close to its reading just before the Black Tuesday stock market crash of October 29, 1929. Other valuation measures, including the equity market’s forward P/E ratio and price-to-book ratio, are also above their long-term averages and appear to be pricing in very optimistic economic and earnings growth scenarios.


In theory, markets should discount all future growth, including long-run effects. Therefore, a small change in the growth trajectory of the economy can translate into a significant increase in stock prices—the “present value” effect. Nonetheless, the market seems to be ignoring some of the potentially anti-growth policies of the Trump administration.3 Textbook economics suggest that high tariffs, trade wars, and highly restrictive immigration policies can impede growth over the long term. Import taxes can also have a more immediate impact, especially if they lead to a cycle of retaliation as other countries raise their own tariffs.

Moreover, the developed world faces a number of significant long-term growth headwinds. In a report on world population aging, the United Nations explains that “the number of older persons (60 and older) has tripled over the last 50 years; it will more than triple again over the next 50 years.”4 Meanwhile, global debt has increased from 269% to 286% of GDP since the fourth quarter of 2007.5


Secular headwinds may explain why the long end of the U.S. Treasury yield curve seems to be anchoring around low long-term growth and low inflation expectations. Since the election, the gap between the 10-year and 30-year rates has fallen from 0.76% to 0.59%, with the 30-year yield remaining close to 3%. This trend is somewhat inconsistent with the Federal Reserve’s (Fed) current path of rate hikes and the general risk-on sentiment after the November elections. A flattening yield curve is generally a recessionary indicator. Our fixed income investors refer to this situation as a “moment of truth”: Either the economy reaches escape velocity or the “long end is right” and it’s an opportunity to buy bonds because growth will disappoint. On the other hand, we must recognize that the starting point is a position of easing, with negative, not neutral, real rates in the front end.


Secular headwinds and high stock valuations explain why we think the market is fragile. For our tactical asset allocation decisions, we focus on the 6- to18-month time horizon. An immediate question remains whether the Fed will be too aggressive as it raises interest rates in 2017, which could effectively cap the economy’s growth. An increase in borrowing costs through a shift in monetary policy—or through tighter financial conditions from higher long-term interest rates and a sharp rise in the value of the U.S. dollar—could reduce capital expenditures, curb asset price appreciation (thereby impeding the “wealth effect”), and weigh on consumer spending.

In fact, we think there’s a limit to how much rates could rise in 2017–2018. With rich equity valuations, if the rate on the 10-year Treasury reaches 2.75%–3.00%, bonds would become increasingly attractive. Importantly, government bonds provide downside protection in the case of a sell-off in risk assets, including equities. Other market risks include rising geopolitical tensions, trade wars, a stronger U.S. dollar, and an emerging market slowdown, particularly in China. Also, our oil analysts have reiterated their view that the world is oversupplied and that oil prices could experience another significant downturn.

The Bottom Line

Markets appear fragile, and there are enough risks over our 6- to 18-month tactical horizon to justify a slight underweight in stocks versus bonds. Within our asset allocation portfolios’ fixed income exposure, we are reallocating to short-duration Treasury inflation protected securities, which offer inflation protection and are less sensitive to changes in real interest rates. In some asset allocation portfolios, we are also adding, as appropriate, to our Global Unconstrained Bond strategy, which focuses on maximizing absolute returns. It’s important to note that we continue to believe in the strategic importance of stocks in our asset allocation portfolios. If any of the aforementioned risks materialize, we will have our dry powder ready to capitalize on market opportunities, including the potential to add to stocks at more attractive levels.

1Source: The Conference Board, Q4, 2016 survey.

2Source: Markit PMIs, January 12–23, 2017, for manufacturing and January 12–25, 2017, for services.

3For more on potential headwinds to the “Trump trade,” we recently published an Asset Allocation perspective titled “The Trump Trade: Four Headwinds the Stock Markets May Have Underestimated” (T. Rowe Price Postelection Asset Allocation perspective, December 12, 2016).

5Source: McKinsey & Co., “Debt and (not much) deleveraging,” February 2015.


Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of February 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Shiller P/E ratio: A valuation measure generally applied to broad equity indexes that uses real per-share earnings over a 10-year period.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown for illustrative purposes only.

T. Rowe Price Investment Services, Inc., Distributor.


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