In a year when most investing markets rose, were tactical adjustments constructive?
Residents of the United States, please read this important information before proceeding
Mostly happy returns
Investing returns from most of the asset classes we follow were positive this year. (Figure 2) Yet even in such a benign climate, divergence in economic growth among developed economies affected asset class performance. In the US, where GDP growth was the strongest, equities yielded double-digit returns. In Europe and Japan, where GDP growth was anaemic-to-negative, equity markets posted more muted gains in local currency terms. However, decoupling between US and global growth led to significant dollar strength, which chipped away at returns for (un-hedged) USD-denominated investors. Overall, our Overweight to Developed Markets Equities served us well this year.
Despite improvements in the economic backdrop, the Fed did not start to increase interest rates this year. This continued low rate environment was an unexpected tailwind for US bonds, where we are mostly Neutral weight. Improving economic data, particularly in the labour market, is building pressure on the Fed to make a move, and when they do, long duration bonds will suffer.
REITS, where we are Neutral, also benefited from low yields, and were the best performing asset class this year.
Emerging Markets Equities, where we are also Neutral, were a mixed bag, with emerging Asia outpacing Latin America and emerging Europe. Russia and its neighbours suffered the worst performance, as conflict in the Ukraine weighed on markets.
Our Underweight to Commodities worked in our favour this year. They were the worst performing asset class with slowing global growth and a strong dollar weighing on prices. In particular, oil prices plunged, reaching lows not seen in five years.
Throughout the year, we tactically adjusted our portfolio allocation as market-moving events shaped our outlook.
Three tactical shifts
Barring any dramatic turn in the last few weeks of 2014, markets will end the year up, but that’s not to say that there weren’t some temporary pullbacks during the year. We took advantage of strength in US markets, taking our Developed Markets Equities positions to Overweight, at attractive entry points throughout the year.
We also shifted away from High Yield Bonds, where higher coupons did not compensate for the risk of potentially widening spreads.
Our specific tactical moves and the rationale for them follow.
1. February 7, 2014: Added to Developed Markets Equities from Cash
US equities took a brief dip in late January/early February after a strong rally into the end of 2013. Investors started to question valuations, particularly in light of the Fed’s plans to reduce asset purchases. But we saw an opportunity. We decided to increase Developed Markets Equities to Overweight from Neutral, in light of encouraging signs of strength in the US economy. Fourth quarter earnings results were coming in according to forecast and economic indicators, particularly GDP growth, showed no signs of slowing. We made the right call: US large cap equities returned 16% since we added.
2. July 22, 2014: Reduced High Yield and Emerging Markets Bonds and added to Cash
We reduced the weight of High Yield Bonds in July, as the asset class had returned over 5% by the middle of the year. The return opportunity these bonds offered appeared increasingly asymmetric in light of the anticipated interest rate normalization and the deteriorating underwriting standards applied to more recently issued debt. The shift away from High Yield was a step in the right direction, as the asset class has declined approximately 3%, since we made the move. While interest rates have not yet started to rise as we expected, High Yield Bonds have come under pressure recently due to their high exposure to the energy sector, where oil prices have brought some borrowers’ cash flows into question.
3. October 16, 2014: Added to Developed Markets Equities from Cash
There was another, and more severe, equity market pull back in mid-October, prompted by concerns over geopolitical developments and the outlook for global economies. While data across Europe suggested anaemic growth, the world’s largest economy – the US – continued to show vitality across an array of measures from jobs to the benefits of lower gas prices. We judged that the US recovery was sufficiently robust and relevant to company revenues around the globe that it could forestall a contraction in the global economy. Again, we took the opportunity to increase our Overweight to our Developed Markets Equity position, specifically to US equities. US large cap equities are up 11% since our increase less than two months ago.