Tactical asset allocation review: why sell in May?

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    Written by Laura Kane, CFA and William Hobbs - June 2014

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Equity and bond markets continued to disagree in May. Economic data and earnings were largely positive, but bond yields continued to suggest a lower-for-longer trend growth environment. Meanwhile, global equities continued to march higher.

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US equities and bonds

May saw equity and fixed income markets witnessing the same events but seemingly coming to divergent conclusions on what they might mean for future US, and therefore global, growth.

Data released last month signalled a pickup in economic activity. Housing starts and building permits surged, and leading indicators pointed to a second-quarter bounce. First-quarter earnings results echoed the same refrain, exceeding expectations in both the large and small- and mid-cap sectors. The unemployment rate dropped to the lowest level since the start of the recession, and inflation hit the Federal Reserve’s elusive 2% target. Consumer and business confidence ticked upward as a result.

In response, US equities moved to new all-time highs, while 10-year Treasury yields remained largely unmoved at around 2.5%. With yields flat to falling in May, US fixed income performance continued to confound consensus expectations. We explore some of the possible reasons for this capital markets scuffle in a separate essay – The bond-yield conundrum. We hesitate to make a tactical call on exactly when the government bond market will cease to defy valuation gravity, however, our very small suggested strategic weight should tell investors that we do not believe this will be the case for long and investors should lower their fixed income portfolio durations (Figure 1).

For the moment, we still see some relative merit in US high yield bonds, where the combination of higher coupons and low default risk make the asset class more attractive than its peers. Within this space, we prefer actively managed credit-related vehicles based on deteriorating credit quality in the loan market.

The upbeat trend for emerging markets bonds continues

Non-US developed market equities

Equity markets in both the UK and continental Europe put in an impressively resilient performance in May – helped in part by voters. In the end (in spite of some fairly hysterical media commentary), European parliamentary elections played out much as we expected. There was a rise in support for the more extreme ends of the political spectrum, aided by very low voter turnout. However, this surge in support for the more populist parties was insufficient to meaningfully change the political equilibrium within the European Parliament. We also had potentially pivotal presidential elections in Ukraine and again the result was broadly benign for markets. Billionaire businessman Petro Poroshenko managed to grab more than half of the vote in what has been declared a legitimate election. Russia has cautiously acknowledged this legitimacy and, although the violence in the east of the country continues, this feels a step forward from earlier in the month. We would continue to caution against trying to call the likely twists and turns in the crisis, but we still expect tensions to relax over time, given both sides’ strong incentive to do so.

The euro crisis will no doubt continue to smoulder while the political and fiscal architecture for the euro remains only partially built. However, we see the weight of history and the lack of credible alternatives forcing the project unevenly forward from here. European parliamentary elections have done nothing to change this view. In this context, we still see European equities, alongside those in the US, as a good place for investors to take selected risk. Earnings headroom remains greatest in Europe, even if the latest earnings season provided little evidence of it.

A weaker currency may help the corporate sector at the margin given its globally well-diversified revenue footprint relative to the US equity market. To this end, June may see the European Central Bank actually start to follow through on its promise to do “whatever it takes” – a change in language in its most recent statement, suggesting that it is no longer happy with medium-term inflation expectations, may indicate that a negative deposit rate and/or some form of targeted liquidity operation are coming our way. This is all in the context of a still fairly sluggish economic recovery, albeit not far from trend, as evidenced by May’s business confidence data.

So far this year, Japanese equities have provided a fairly brutal reminder, in both constant and local currency terms, of why we prefer to sit on the fence. To date, Japanese authorities have deployed headline-grabbing monetary and fiscal measures in their attempts to shake the country out of its economic torpor. There were some signs of life in the first-quarter’s GDP data, however, the bottom-up reform and liberalisation that we would need to see before comfortably taking an active position on the market, remains largely absent.

Emerging markets equities and bonds

Emerging markets equities were the strongest performer in May, returning 4.5%. Russian and Indian stocks were the stand-out markets, with the former benefiting from a more moderate posture from the Kremlin in the wake of the successful Ukrainian elections (Figure 2). Meanwhile Indian equities had been rallying for several months in anticipation of a victory for Narendra Modi’s Bharatiya Janata Party and the election itself didn’t disappoint. Indian voters haven’t spoken with such a unified voice since 1984, when Rajiv Gandhi led the Indian National Congress Party to a landslide victory following the assassination of his mother, Indira Gandhi.

Even with the strength of his party’s mandate, it is too early to say how much progress Mr. Modi will manage in an economy famed for its constrictive bureaucracy. Expectations are clearly high. We are not encouraging direct exposure ourselves, but a reinvigorated India would certainly be good for the region’s economy and equity markets.

For our part, our optimism on emerging stocks is more strategic (five years) than tactical (three to six months). We remain wary of emerging market bonds, in spite of a 2.2% (unhedged local currency) return for May, particularly those denominated in local currency.


After rallying at the start of the year, commodity returns flattened out in May, ending the month down 220 basis points. Agricultural commodities slumped from early-year highs. Coffee, for example, fell from April peaks, as Brazilian growers and dealers exported stockpiled beans to capitalise on higher prices.

Industrial metals posted modest returns. Nickel prices surged in May due to supply concerns stemming from an export ban by Indonesia, and the potential for more sanctions by the US and Europe against Russia, which is home to the biggest producer of the refined metal.

Despite the recent strength in commodities, we remain underweight the asset class. This year’s tailwinds, particularly in the agricultural sector, are likely temporary. Further, an increase in US interest rates may lessen the attractiveness of commodities as a portfolio diversifier.