Federal Reservations

  • Written by 
  • 19/07/2016

As the world economy continues to grow at above stall speed and the cycle end appears as a relatively distant, albeit inevitable, prospect, we share our thoughts behind our recommended tactical positioning. We continue to believe that investors remain best served by leaning portfolios towards Developed Markets Equities, and the US and Continental Europe in particular.

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We maintain a Strategic Asset Allocation 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 to six month) outlook. Here, we share our latest thinking on our key tactical tilts.

Developed Markets Equities: Overweight (changed 6 July 2016)

Developed equity markets so far remain comfortably above the lows plumbed earlier in the year in spite of the turbulence that has followed the UK’s historic referendum. The TAC recently moved from a neutral to overweight position in UK large cap equities within Developed Markets Equities. This move was funded by increasing the underweight in Japanese equities. Both changes refer to the unhedged share classes. The defensive sector composition of the UK stock market, with a heavy leaning towards international banks, consumer staples and pharmaceuticals in particular should set the index in good stead in the event of a downturn in the UK economy.

We retain our view that the still under-appreciated prospects for global growth and inflation will likely be the primary driver of investment returns on a six-month view. It is these prospects that are likely to be most influential in the performance of capital markets, rather than the ever murky political backdrop.

On this, we still advise investors not to underestimate the US consumer, particularly with real disposable income growing at such a healthy pace. This may surprise those again calling for US profit margins to continue rolling over. Such forecasts may both understate the negative effect of energy sector earnings over the last year and a half and overstate its future role given the sector’s now much diminished contribution to quoted index earnings.

Our favoured developed equity regions are the US, UK and Continental Europe. In these regions, we see earnings estimates as too conservative and valuations unremarkable.

The under-appreciated prospects for global growth and inflation will likely be the primary driver of investment returns on a six-month view

Emerging Markets Equities: Neutral

The TAC moved their recommended position in Emerging Markets Equities up to neutral in January. We are looking for a more visible turn in earnings momentum before adopting a positive tactical posture. The bounce in China’s property market indicators, which now look to be in the process of peaking, has helped to stabilise sentiment towards the asset class. Meanwhile, a perhaps temporary reassessment of the pace of projected US interest rate rises may also be helpful.

Within Emerging Markets Equities, Asia remains our preferred region, with Korea, Taiwan and China (offshore) our highest conviction country bets on a strategic basis. The expected pick-up in global trade is central to this view. We continue to watch US and Chinese imports for any signs of this.

Cash & Short-Maturity Bonds: Neutral (decreased 6 July 2016)

Given ongoing market volatility, cash continues to play a pivotal portfolio insulation role. While the fixed income universe remains unattractive at current extreme valuations, cash offers a source of funds to invest into other asset classes when appropriate opportunities arise. Evidence of some returning inflation in the US obviously needs to be watched very carefully.

Developed Government Bonds: Neutral

With nominal yields on large chunks of the government bond universe negative or close to it, investors will likely have to work hard to make real returns from these levels over the next several years. Our view remains that such valuations underestimate the underlying inflationary pressures within the US economy in particular, something that incoming inflation data pay some testament to. While the level of (returns insensitive) central bank ownership suggests that the bond market may lag a pick-up in inflation, our continuing small strategic and tactical allocation to the area suggests that higher real returns lie elsewhere.

Given ongoing recent market volatility, cash continues to play a pivotal portfolio insulation role

Investment Grade Bonds: Underweight

The spread of investment grade credit over government bond yields remains close to its ten-year average. However, this leaves nominal yields in high quality corporate credit low in absolute terms and may make the job of those trying to make positive real returns difficult.

High Yield & Emerging Markets Bonds: Overweight (increased 6 July 2016)

The TAC recently moved from an underweight to overweight position in High Yield and Emerging Markets Bonds by adding to Global High Yield within the US dollar share classes. This was funded by moving from an overweight to neutral position in Cash & ShortMaturity Bonds. Given our more sanguine take on the various risks to global growth and inflation, yields on junk credit look attractive on a risk reward basis. Emerging Markets Bonds are expensive and remain vulnerable to a reversal of inflows during the slow process of monetary normalisation.

Commodities: Neutral (increased 13 May 2016)

We have now closed our long held underweight in the commodity complex. US monetary normalisation will likely provide a headwind, but the bounce in China’s property market indicators looks sufficient to offset this. Investors are likely best served by tilting their commodity exposure towards oil and away from gold where possible, with the latter still particularly vulnerable to further US interest rate rises. We see oil prices continuing to drift higher over the coming 12 – 18 months as the market’s worst fears on China fail to materialise and a smaller than suspected surplus is worked through.

Real Estate: Neutral

Recent volatility has served as a timely reminder of the importance of maintaining a diversified portfolio with the ability to weather a number of market environments, and we continue to encourage clients to ensure that they are fully allocated to Real Estate. We are in the process of reviewing our holdings within UK real estate.

Alternative Trading Strategies: Underweight (decreased 13 May)

The previous underweight in Commodities shifts to Alternative Trading Strategies (ATS). This is primarily a function of the difference in volatilities for the two asset classes. There is less risk being underweight the lower volatility ATS in the current market environment in our opinion. Regulation and lower leverage leave this diversifying asset class however without tactical appeal.