As the drumbeat of monetary normalisation gets ever louder, we explain our current thoughts behind our recommended tactical positioning. We still see investors being best served by leaning portfolios towards developed equities.
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We maintain a Strategic Asset Allocation view for five risk profiles, based on our outlook for each of the asset classes. Our Tactical Allocation Committee (TAC), comprised of our senior investment strategists and portfolio managers, regularly assesses the need for tactical adjustments to those allocations, based on our shorter-term (three-six month) outlook. Here, we share our latest thinking on our key tactical tilts.
Developed Markets Equities: Overweight
Continental Europe remains our highest conviction overweight call within Developed Markets Equities. It is here where corporate profitability has the greatest scope to recover. There will remain plenty to unsettle investors in 2016. Growing border controls in the wake of the tragic events in Paris will weigh on the costs of doing business, while the recent surge in immigration may well stoke the fires of the political extremities in some countries. However, we still believe that the European economic recovery is sufficiently well entrenched to be able to withstand these extra frictions.
In the US, worries about a peak in the profits cycle again look premature to us. The quoted corporate sector’s earnings prospects may look a little less concerning when the negative effects of the dramatic oil price declines of 2014, combined with the dollar’s ascent, start to wash out of the data. US equities do not seem to be especially expensive on the metrics that we look at, though we would not expect returns from here to be driven by valuation multiple expansion. However, with the US and world economy likely to continue chugging along without alarming consequences, we see investors being well compensated from banking whatever dividend yield and dividend growth the corporate sector manages to generate over the year.
“Revenue growth may look less worryingly soft as the effects of plunging oil prices fade”
In aggregate, Developed Market Equity returns are likely to remain attractive, in both relative and absolute terms, as corporate profits continue to rise amidst rising corporate leverage and continuing revenue growth. Banks and life assurers should benefit as these sectors are most positively correlated with rising interest rates and a steepening yield curve while an improving capital expenditure backdrop should help industrials and technology.
Cash & Short Maturity Bonds: Overweight
Extreme valuations have significantly reduced the attraction of the wider fixed income universe as portfolio insulation. As a result, cash represents an asset where the nominal value will remain stable in the event of serious market disturbances. Alongside this portfolio buffer role, cash is a source of funds to invest into other asset classes when appropriate opportunities arise.
Developed Government Bonds: Neutral
The return of more inflation over the course of next year is likely to make life difficult for the still very expensive government bond market. We believe that the euro area can continue to relatively outperform in what is likely to be a testing time for most bonds. A reappraisal of the path of interest rates in the US and UK by the bond markets could see a temporary reduction in global risk appetite, which could see spreads to riskier fixed income instruments widen from here. We suggest keeping duration short.
High Yield & Emerging Markets Bonds: Underweight
While the Tactical Allocation Committee took the decision to add back to our recommended high yield exposure within portfolios in the third quarter, there remain risks to the sub sector, particularly within the US market where energy-related defaults should rise from here amidst depressed oil prices. There are also well reported concerns about liquidity, which will be particularly relevant in the event of a more disorderly market. However, we see sufficient attraction with the yield at current levels to help compensate investors for some of these risks.
“Developed government bonds in the euro area should continue to relatively outperform in what is likely to be a testing time for most bonds”
Emerging Markets Equities: Underweight
For the moment, we remain tactically underweight Emerging Markets Equities. However, valuations look interesting, particularly in Emerging Asia. We continue to see China as more likely avoiding the hard landing that many still worry about. Within the Emerging Market Equity space, we retain our long held preference for Asia ex-Japan, more specifically, Korea, Taiwan and China.
Investment Grade Bonds: Underweight
Similar to High Yield Bonds, we have concerns regarding available liquidity over the next 12 months. Furthermore, the asset class remains expensive in absolute terms and vulnerable to rising issuance. However, it is worth noting that the spread of investment grade credit over government bond yields remains within its historic range.
We retain an underweight positioning due to the impending approach of US monetary normalisation, which is weighing on the asset class. The prices of key commodities such as oil and copper are close to finding a floor, but the supply picture still looks a little daunting for those eager to take a more positive view on the space. Gold remains particularly vulnerable to approaching US interest rate hikes.