The prospects for the US private sector remain bright with the employment backdrop continuing to normalise and wages starting to turn up more forcefully, while incoming data for Europe continue to suggest the economic recovery is broadening and strengthening with the continued improvement in the credit backdrop instrumental. However, clearly risks remain in the global economy.
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Here, William Hobbs, Head of UK and Europe Investment Strategy, talks to Rupert Howard, Senior Portfolio Manager, about how he is positioning portfolios given the prevailing macroeconomic environment.
Will: It has been a turbulent quarter for capital markets, particularly the fixed income complex as Greek negotiations collapsed again, while data pointed to a less questionable growth outlook and a little less pessimism on the prospects for inflation. In the context of all this, what has worked well for the portfolio over the period and what has not done so well?
Rupert: Over the last few months, we have continued to tilt our equity exposure away from the US and emerging markets towards Europe. It is this pro-European approach which has been accretive to performance as European equity markets have performed well since the start of the year (Figure 1). Furthermore, while returns in the second quarter have not been as strong as the first quarter, the recent stabilisation in currency trends has been helpful; sterling has rebounded against the US dollar while the euro has stabilised for the moment. As a result, equity market returns have not been diluted by further euro weakness.
The recent reversal in the government bond market, which you allude to, has obviously hit performance – the inverse relationship between bond prices and yields means that as yields rise, bond prices fall and vice versa. However, we have consistently adopted a short-duration strategy in bonds – duration is a measure of the sensitivity of a bond’s price to changes in interest rates – which has helped us to insulate portfolios against this risk.
Will: As you mentioned above, the bank’s recent strategy has seen a rotation within developed markets equities from the US and emerging markets to Europe. Do you have any sectoral or other slants within the region – how are you expressing this preference for Europe within portfolios?
Rupert: As many in the industry have been pointing out for some time, there is a good deal of scope for European corporate earnings to catch up with those of their peers in the US (Figure 2). A large part of this story revolves around a recovery in the profitability of the region’s banking sector.
As loan growth continues to pick up and a little returning inflation continues to push yields a little higher, the recapitalised and rebooted banking sector should start to find life a bit easier. We have exposure to this theme within portfolios. To balance that riskier exposure, we also have strong representation from the higher-quality corners of the market such as healthcare.
Now, alongside this European exposure, it’s important to remember that we have not abandoned US equities in the portfolio. At the beginning of the year, we felt, in line with the thoughts from the investment strategy team, that US assets in general were looking tactically a little overbought. This is now much less the case and with the US economy now looking well clear of its winter soft patch, we might see our US equity exposure contribute a little more to second-half performance.
Will: The market seems just about agreed that we are going to see the first interest rate hike since 2006 in the US in September. Is this something that worries you with regards to your portfolio positioning?
Rupert: The debate in markets has been so focused on when the Federal Reserve will start raising interest rates, but for us the more important point to consider is not so much the starting point, but the pace of interest rate rises from that starting point. The market’s current expectation is that neither the world nor the US economy will generate sufficient growth or inflation to force the central bank to raise interest rates at anything other than a pedestrian pace. The risk of this for us is to the upside.
There may already be a little more inflation in the pipeline than some are suggesting, with the US jobs market now pretty much healed. While our portfolios should do fine in the eventuality that interest rates only rise gradually over the coming years, our short duration, light footprint within the fixed income space alongside our tactical underweight to commodities and emerging markets equities should mean that we are prepared for a steeper path of interest rate rises if that does indeed materialise.
Will: You mention that tactical underweight to emerging markets equities, but the strategic weight speaks of a strong longer-term conviction. How are you expressing this longer-term conviction in portfolios?
Rupert: There remains a very strong strategic argument for having some exposure to emerging markets equities in portfolios. The weight of demographics will tell over time, as you guys in strategy have been pointing out for some time. This argument is most obvious in Asia and this is where we have the bulk of our exposure, both in single stocks and funds. This is where structural growth remains the strongest; governance is better and macroeconomic policies more credible.
Will: Hedge funds (UCITS) have delivered strong year-to-date performance while offering low correlation to other asset classes. Is this recent performance due to a confluence of favourable events or are we witnessing more of a structural change?
Hedge funds can dampen risk, diversify portfolios and spread exposure
Rupert: Hedge funds have struggled over the last few years, having failed both to protect investors from the financial crisis and to deliver meaningful returns in its aftermath. One of the reasons for this may be attributed to leverage being removed from the system which has made it harder for hedge funds to deliver decent returns, while the bond carry trade has all but disappeared. The last six months, however, have seen good returns for investors across a range of strategies (these include equity long/short, arbitrage, event-driven, global macro etc.). In addition, we have been fortunate in that a number of individual managers have performed well on a relative basis.
We have maintained a relatively large exposure to hedge funds as we seek low correlation to equities and low volatility. By generating mid-to-high single-digit returns, hedge funds offer the ‘look and feel’ of the bond market but are not confronted by the excessive valuations that concern us within fixed income. Furthermore, hedge funds can dampen risk, diversify portfolios and spread exposure. They are not designed to be highly leveraged, high beta, high volatility speculative investments.
Hedge funds have performed well year to date in Europe as the industry moves to a more regulated and transparent structure where liquidity has become increasingly available.
The hedge funds in which we are invested are regulated under the UCITS scheme which provides better transparency, as well as daily or weekly liquidity. There has not been a structural change so to speak and, therefore, it is important not to take good returns for granted. However, the hedge fund community has embraced the shift towards the new regulatory environment and more hedge fund managers are replicating their strategies in a more transparent, liquid structure. We believe that this is good for us in terms of access to new ideas and new strategies.
Hedge fund strategies
Long/short: An investing strategy which takes long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline. A long/short equity strategy seeks to minimise market exposure, while profiting from stock gains in the long positions and price declines in the short positions.
Arbitrage: The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.
Event-driven: An investing strategy that seeks to exploit pricing inefficiencies that may occur before or after a corporate event, such as a bankruptcy, merger, acquisition or spin-off.
Global Macro: A hedge fund strategy that bases its holdings – such as long and short positions in various equity, fixed income, currency, and futures markets – primarily on overall economic and political views of various countries.