Yet another Greek denouement

  • Written by 

    Will Hobbs, Q3 2015

  • 08/07/2015

A core principle of our investment philosophy is that clients maintain diversified portfolios, with exposure to nine different asset classes in a mix that is customised to each client’s risk tolerance and personal needs.

Preparing portfolios for volatility 4 of 7 The return of (a little) inflation 2 of 7

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We maintain a Strategic Asset Allocation view for five risk profiles, based on our five-year outlook for each of the asset classes. Our Tactical Asset 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

Despite our concerns that the market may still be underestimating the pace of interest rate hikes in coming years, the prospects for US consumption remain bright in our view – the employment backdrop continues to improve and wages are correspondingly starting to pick up. As the year progresses, the global economic recovery should pick up some momentum, with the warming backdrop in the US at its heart. This suggests that developed market corporations in aggregate, enjoying as they do a well-diversified global revenue footprint, will continue to generate sufficient revenue growth to cover their fixed costs at the least.

Within the developed markets equity space, we continue to place the majority of our tactical faith in continental European and US equities. For the former, the scope for higher levels of profitability from a still depressed base suggests that earnings growth in the region may outpace that seen in other regions – we are starting to see the more persistent positive earnings forecast revisions that would support this narrative. Recent data support the case for a broadening and strengthening economic recovery in the region, with the continued improvement in the credit backdrop instrumental.

For the US, there is less scope for profitability to move higher, though respectable levels of revenue growth (ex energy) should still see earnings grow broadly in line with their long-term average and suggests investors will still be amply compensated even if admittedly lofty valuations move no higher from here.

Higher-yielding equities may be vulnerable as yields on other safer asset classes become more appealing

At the sector level, we continue to favour those areas most positively correlated with rising interest rates and a steepening yield curve, specifically banks and life assurers, as well as those sectors likely to benefit from the improving capital expenditure backdrop, such as industrials and technology. Higher-yielding equities may be vulnerable as yields on other safer asset classes become more appealing. However, we expect equity returns will be attractive, in both relative and absolute terms, as corporate profits continue to rise amidst rising corporate leverage and continuing revenue growth.

Developed Government Bonds: Neutral

The business cycle, not creditworthiness, holds the key still: if economies continue to grow, expensive bonds – and duration – will start to look unattractive again. A little returning inflation, alongside a marginally less questionable outlook for the world economy may mean that the ongoing correction is only in its infancy.

We still just about prefer the eurozone. The benchmarks include Italian and Spanish bonds, which are more pro-cyclical than Treasuries, Gilts or Bunds, and the ECB will likely remain in dovish mode for some time yet.

We continue to suggest stepping carefully and lightly within the fixed income universe and keeping duration low.

Cash & Short Maturity Bonds: Strong Overweight

The overweight to cash serves a dual purpose. First, in a world where extreme valuations have significantly reduced the attraction of the wider fixed income universe as a portfolio buffer, cash represents an asset where the nominal value will remain stable in the event of serious market disturbances. Alongside this portfolio insulation role, we still see cash as a likely source of funds to deploy opportunistically into other asset classes as more durable volatility materialises over coming months and quarters.

High Yield & Emerging Markets Bonds: Strong Underweight

Both hard and local currency emerging markets bonds look a little less expensive than in the recent past. However, much as in the rest of the global fixed income universe, yields remain well below historic norms. Both sub-asset-classes are vulnerable to further outflows as global liquidity is reined in over coming quarters. Of the two sub-sectors, we tend towards hard currency over local currency with the prospects for a further appreciation in the US dollar influential. There is less interest rate risk in high yield traditionally, though current concerns around liquidity in the event of a more disorderly march higher in government bond yields keep us underweight relative to the benchmark for the moment.

Bonds and investment grade credit are expensive and appear complacent to the potential for returning inflation

Emerging Markets Equities: Underweight

Despite a tactically cautious stance in Emerging Markets Equities due to slowing Chinese growth, lower commodity prices, and looming Fed rate hikes, we continue to recommend a strong strategic weight to the asset class due to attractive long-term prospects and solid demographic foundations. In Asia, wages are sustainably rising at a faster pace than those of their Western counterparts. This trend should see the ranks of the middle class continue to swell in the region, which in turn should create a long-term structural bid for capital markets assets. We specifically recommend China, Korea and Taiwan as our preferred markets. Elsewhere, Latin America, as a net commodity exporter, is suffering from the weakness in commodity prices and a host of domestic political problems.

Investment Grade Bonds: Underweight

Investment grade credit is expensive in absolute terms, even if the spread to government bond yields is within its historic range. The asset class is vulnerable to rising issuance. Much as with high yield, there are some concerns with regards to liquidity.

Commodities: Underweight

Our continuing underweight to Commodities is part of our attempt to insulate portfolios from the likely ripples from US monetary normalisation. Gold remains particularly vulnerable to impending US interest rate hikes. Oil and industrial metals tend to be negatively correlated with the dollar. A revival of the strengthening dollar trend is likely to be a negative across all major commodity markets. We note that, despite ongoing conflict in several oil producing countries, the impact of geopolitical risks on oil supply currently remains relatively muted. One area to watch is the ongoing negotiations in Iran. If the deal were to include a more dramatic pace of sanction relief than currently priced in, oil prices could suffer.

Duration: the long, the short and the negative

Duration is a measure of a bond’s sensitivity to changes in interest rates. For every percentage point that rates move up or down, a bond can be expected to move in the opposite direction by a percentage equal to its duration in years. If rates go up 1%, a bond with a duration of five years would be expected to lose 5% of its value. The longer the duration, the more sensitive the bond is to interest rate fluctuations.

Shortening duration could be a technique to blunt interest rate sensitivity. This can be achieved by increasing exposure to bonds with shorter maturities, or through the use of derivatives such as interest rate swaps, interest rate options and bond futures.

By selling a Treasury futures contract, an investor can gain interest rate exposure that is the opposite of the underlying bond. If an investor sells enough contracts, this could take the duration negative. A bond with a negative duration should, in theory, appreciate in value if interest rates rise.