Rate expectations

  • Written by 

    William Hobbs, Q4 2015

  • 12/10/2015

A core principle of our Wealth 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, risk capacity and personal needs.

The perfect storm 4 of 9 The butterfly effect 2 of 9

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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-six month) outlook. Here, we share our latest thinking on our key tactical tilts.

We still expect global economic growth to accelerate in the final quarter of the year, with the US economy at the heart of this acceleration

Developed Markets Equities: Overweight

We still expect global economic growth to accelerate in the final quarter of the year, with the US economy at the heart of this acceleration. This is likely to be accompanied by higher interest rates across the government curve, and may usher in a period of more durable volatility for capital markets. Wages in the US are yet to turn up more forcefully, a key strut of our expectation that interest rates will likely have to rise a little faster than the consensus currently expects over the next couple of years. However, a range of evidence points to labour supply starting to run thin, which would suggest that we won’t be waiting long.

Meanwhile, developed markets equity exposure remains the most easily accessible beneficiary from an increase in deal activity, which should exert upwards pressure on wider equity market valuations. Although higher borrowing costs may have a dampening effect, interest rates across the curve will likely rise as a result of increasing confidence in the outlook for global growth. “Such confidence is already visible in the increasing deal volumes and suggests that there may yet be more to come” (M&A, In Focus, 7 August 2015).

On a regional basis, we continue to have a tactical preference for continental European and US equities. It is still the European corporate sector which looks to have the most scope to boost profits. Meanwhile, data support the case for a broadening and strengthening economic recovery in the region, with the continued improvement in the credit backdrop instrumental. In 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 sufficiently compensated even if valuations do not move significantly higher.

We have a preference for banks and life assurers as these sectors are most positively correlated with rising interest rates and a steepening yield curve. Elsewhere, industrials and technology should benefit from an improving capital expenditure backdrop. 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.

On 25 August 2015, the TAC reduced exposure to Cash & Short Maturity Bonds and increased exposure to Developed Markets Equities, stating that, “we’ve long expected the approach of US interest rate rises to usher in a more sustained period of volatility for capital markets. We’ve taken action to protect portfolios where possible from such volatility raising the allocation to cash along the way. However, now we see an opportunity to put some cash back to work in developed equity markets, with valuations now looking more definitively appealing and market sentiment clearly less buoyant. There is certainly the potential for equity markets to fall further from here; however, we feel the current pullback already presents an attractive opportunity and therefore advocate using cash to add to our overweight to Developed Markets Equities.”

Cash & Short Maturity Bonds: Overweight (moved from ‘Strong
Overweight’ on 25 August 2015)

Extreme valuations have significantly reduced the attraction of the wider fixed income universe as a portfolio buffer. As a result, cash represents an asset where the nominal value will remain stable in the event of serious market disturbances. Alongside this portfolio insulation role, cash is a source of funds to deploy opportunistically into other asset classes as more durable volatility materialises over coming quarters.

On 24 July 2015, the TAC reduced exposure to Developed Markets Equities and increased exposure to Cash & Short Maturity Bonds, stating that, “while corporate profits may well benefit from increasing economic warmth, the corollary may well be a steeper assumed path of interest rates in the US than currently priced in. This prospect, along with the approach of the first interest rate rise in September, may well herald a more persistent period of volatility in capital markets than that experienced around the latest incarnation of the Greek crisis for example. The Tactical Allocation Committee believes that this anticipated turbulence may be sufficiently durable to warrant taking preventative action in portfolios and it is advocating taking some profit, without meaningfully changing our convictions.”

Developed Government Bonds: Neutral

Developed government bonds remain expensive with the potential to become even less attractive if economies continue to grow. However, a more forceful wage inflation picture is patchily starting to emerge in the US and the UK, which may encourage the bond markets to reappraise their currently benign view of the path of interest rate rises in both regions.

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 (moved from ‘Strong Underweight’ on 14 August 2015)

Yields across both hard and local currency emerging markets bonds remain below historic norms. As global liquidity continues to diminish over the rest of the year, we expect both sub asset classes to become increasingly vulnerable to further outflows. However, we continue to have a preference for hard currency emerging markets bonds over local currency equivalents due to the impact of further US dollar appreciation. Despite current concerns around liquidity, the TAC has recently reduced its underweight to high yield relative to the benchmark due to the compelling yield on offer. Within the fixed income complex, there is also less interest rate sensitivity in high yield traditionally.

On 14 August 2015, the TAC reduced exposure to Cash and Short Maturity Bonds and increased exposure to High Yield, stating that, “the yield available from High Yield bonds now looks sufficiently appealing to protect against market illiquidity. While the impact on the energy sector (biggest sector within the global high yield market) of falling oil prices remains a risk, the committee believes there is an asymmetric risk in the return profile of the asset class at this stance, with the likelihood for upside being better than the one for downside. Valuation metrics are fair in value, making the carry above cash particularly interesting. All of this warrants the committee reducing our underweight to this asset class, with the potential to add more if spreads were to widen further. The scale of the move does not meaningfully change the TAC’s convictions in either Cash or High Yield bonds.”

Emerging Markets Equities: Underweight

Tactically, Emerging Markets Equities remain an underweight position due to slowing Chinese growth, lower commodity prices, and looming Fed rate hikes. However, on a strategic basis, Emerging Markets Equities continue to offer a compelling investment case 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. “This may see their market capitalisation, as a proportion of their respective global markets, move to reflect Asia’s contribution to the global population” (Time in the market, In Focus, 31 July 2015).

On a regional basis, we specifically recommend China (offshore), Korea and Taiwan as our preferred markets. The expected pick up in global trade in the final quarter of the year is central to this view. 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

The spread of investment grade credit over government bond yields remains within its historic range but the asset class is expensive in absolute terms and vulnerable to rising issuance.

Commodities: Underweight

The approach of US monetary normalisation is weighing on Commodities and corroborates our underweight positioning, which is intended to insulate portfolios from a revival in the strength of the dollar. Gold remains particularly vulnerable to impending US interest rate hikes while signs of weakness in India and China will also add to concerns about the outlook for the metal. We may be towards the bottom end of oil’s new trading range, however the prospects for supply may continue to weigh on oil prices for a while yet.