Tactical asset allocation review: summer lovin’

  • Written by 

    William Hobbs 22 June 2014

ISIS and central bankers dominated the headlines in a month that saw positive returns from nearly all asset classes, in keeping with the rest of the first half. The trends were more nuanced at the sub asset class and regional level as explored in a bit more detail below. Investors should be prepared for the second half to see less serene progress in capital markets as monetary normalisation looms larger in much of the developed world.

ECB acts on deflation risks 4 of 5

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The world’s most important economy continued to look well set for an acceleration in the second half of the year. Unemployment continued to fall, which, alongside rising asset values, bodes well for future consumption. Meanwhile the new orders component of the trusty ISM survey pointed to similarly brighter times ahead. In the face of this, alongside some perkier inflation readings, the Federal Reserve remained defiantly dovish.

Against this backdrop, Equities did well unsurprisingly, rising over 2%, with rising earnings forecasts a further tailwind. The bond market was a bit quieter, with the yield on the 10 year treasury rising five basis points and spreads continuing to creep unevenly lower in the investment grade and junk bond complexes. We continue to suggest that investors tread carefully and lightly within the fixed income space, given that central bank forward guidance has its limitations, as the UK economy has very recently illustrated.

Figure 1 shows a graph of the US ISM pointing to better times ahead. Figure 2 shows a graph of gilts grappling with monetary normalisation.


While the US looks poised to accelerate into the second half of the year, the prospects for the continental European economic recovery continue to look more pedestrian. Government-debt loads remain high and rising in several peripheral countries, with primary balances still some distance away from debt reducing thresholds. Meanwhile, both access to and demand for credit in much of the private sector in the periphery is likely to remain patchy for the moment, in spite of the European Central Bank (ECB)’s best efforts (see ECB acts on deflations risks). From historically elevated levels, unemployment is starting to turn a corner in many areas, and this may support growth into the end of the year. Overall, the economic outlook is for gradual and uneven progress for the rest of 2014 as suggested by this month’s subdued business confidence data.

With monetary policy in Europe already diverging from that in the UK and the US, and set to continue to do so, peripheral government bonds may continue to outperform those of their developed-market peers facing more impending monetary normalisation as was the case in June. Nonetheless, with nominal benchmark yields for Spain and Italy only fractionally above the deservedly higher-rated UK and US benchmark issues; the scope for lower yields in peripheral markets has to be limited.

In spite of succumbing to some fairly broad-based profit taking in June, we still suspect clients will benefit from owning a mix of both peripheral and core European equities. The periphery is where the quoted-corporate sector’s earnings have the furthest to travel to regain previously scaled peaks and, although some of this is already factored into premium valuations, we still see more to go for.

The UK economic recovery remains an altogether different beast…

The UK economic recovery remains an altogether different beast. June readings of unemployment, business confidence and retail sales continued to suggest that the Bank of England may be the first of the major Western central banks to actually raise interest rates. Unsurprisingly, Gilts underperformed Treasuries and Bunds across the curve over the month as bond investors grappled with impending interest rate rises. UK equities similarly struggled relative to peers over the month, dragged lower by the more domestically focused sectors such as consumer discretionary.


Japanese equities topped the developed market leader board in June as Prime Minister Abe’s so called third arrow started to take shape. The first and second arrows carried packages of fiscal and monetary measures into the economy with some success. However, it is bottom up reform and liberalisation, intended for the third arrow, that has remained largely absent from most attempts to jump start the Japanese economy over the last few decades. The plan announced towards the end of June focused on three main areas – cutting the corporate tax rate below 30% (to be done in phases), pension investment reform (allocating more to domestic stocks from Japanese government bonds) and revising the tax system to promote female participation in the workforce. These are all important measures and, assuming they all make it through to implementation, will no doubt raise Japan’s potential growth rate. However, we would likely need to see more progress still, particularly on the constrictive labour force termination laws, before making an active recommendation on Japanese equities.

Emerging markets

Emerging market equities rose over 2% in June with Latin America and Asia leading the asset class higher. A slightly firmer tone to the data out of China was influential in helping to assuage some of the more apocalyptic fears surrounding the ongoing Chinese property market correction. The second half of the year will likely prove more challenging for emerging market equities and bonds, given our expectation of higher US Treasury yields.


Oil prices broke out of their multi-month range in June on the back of returning sectarian tensions in Iraq. Having taken over the second largest city, Mosul, in the early part of the month, jihadist extremist group ISIS went on to take over Iraq’s largest oil refinery and disrupt a key pipeline in northern Iraq on its march towards Baghdad. To-date most of the fighting has remained in the northern territories, disrupting domestic rather than export focused supply. However, we continue to suggest slanting holdings within the commodity space towards oil in deference to the threat that the conflict will widen in scope. We retain a tactical underweight on the overall commodity complex – a function of our positive view on the US dollar and the likely negative impact on the space from looming interest rises in the developed world.

Figure 3 shows a chart of tactical asset allocation tilts and the strategic asset allocation benchmark (moderate risk profile)