We see the global economy accelerating in the final quarter, with an increasingly buoyant US private sector at its heart. Trends in consumption and investment are comparable with pre-crisis trends in the world’s most important capitalist economy. Incoming data on Europe continue to suggest the economic recovery is broadening and strengthening with the continued improvement in the credit backdrop helpful.
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Here, William Hobbs, Head of Investment Strategy, UK and Europe, talks to Rupert Howard, Senior Portfolio Manager, about how he is positioning portfolios given the recent correction in markets and ongoing uncertainty over the pace and timing of impending US rate hikes.
Will: It has been a challenging quarter with concerns over a slowdown in China dominating the headlines and causing severe gyrations across all asset classes. During this period of heightened volatility, can you tell us what has worked well for portfolios and what has detracted from performance?
Rupert: The third quarter has been a frustrating time for us as investors as most of the portfolios have given up the bulk of gains made in the first half of the year (Figure 1). This demonstrates just how difficult it has been to generate positive returns for clients in an environment where bond yields remain stubbornly low and equity markets have seen a significant pick-up in volatility.
Hedge funds have weathered the storm reasonably well, delivering positive performance
On the other hand, hedge funds have been more encouraging and have weathered the storm reasonably well, delivering positive performance. Elsewhere within the alternatives space, Commodities have undoubtedly been the worst performers but fortunately for us the impact has been small due to our low allocation to the asset class.
It is hard to highlight those areas of outstanding performance this year due to the challenging environment. At the start of the year, European equities got off to a flyer as the burgeoning economic recovery became more evident. As we had hoped, earnings growth has been strong in Europe but, more recently, geopolitical concerns and China in particular, have unsettled
markets and caused a significant correction.
At a regional level, the US has been caught up in the market maelstrom despite its growing economic recovery. The emerging markets have suffered a challenging year due to the slowdown in global growth, exposure to US dollar strength and sensitivity to falling commodity prices; these factors have combined to create something of a perfect storm. In the fixed income complex, the start of the year saw low yields due to deflationary fears. As these fears diminished, yields have risen causing bond prices to fall. As a result, we have had to turn towards the more risky high yield space to make money.
Will: The Tactical Allocation Committee has made a number of changes over the quarter. July saw the committee advocate taking profits out of Developed Markets Equities after a strong run. August saw a move into High Yield bonds due to the compelling yield on offer and then a move back into Developed Markets Equities as the global turmoil pushed equity market valuations to appealing levels. How have these changes demonstrated your approach to effective portfolio management during such a turbulent period?
Rupert: From a tactical perspective, we have been reasonably proactive in reducing our equity exposure in the early summer when sentiment was positive, markets were buoyant and there were few clouds on the horizon. This seemed like a good time to take profits after a period of strong gains.
High Yield bonds have moved from paying a 5% yield 12 months ago to 7% today (Figure 2). Given the fact that we do not envisage an imminent recession, we believe this level adequately compensates us for the additional risk. As these tactical changes demonstrate, in most situations, our approach to portfolio management is incremental, building or reducing positions gradually over time.
Having seen the volatility in August, we maintain our longer-term conviction that the economic cycle still has legs and that the economies of the US and Europe remain strong. As markets have corrected, it is only logical to take advantage, putting cash back to work and picking up quality assets at decent prices.
We are used to these recent bouts of volatility and, in managing portfolios, we attempt to sift through the market noise of daily news flow to focus on our long-term investment narrative. If we are confident that this is not a signal of inflection in the economic cycle, as is the case here, then these periods of volatility offer attractive opportunities to put our cash to work at increasingly compelling valuations.
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: In “Misplaced gloom” (In Focus, 24 July 2015), the Investment Strategy team commented that, “the most visible potential bumps in the road ahead relate to the approach of tighter monetary policy in the US and UK.” In light of this view, how are you positioning portfolios across assets which are sensitive to further US dollar appreciation?
Rupert: We have been consistently long US dollar denominated assets in portfolios both this year and last, and this has been accretive to performance. We have maintained an underweight to emerging markets currencies, emerging markets debt (in local currency terms, in particular), Emerging Markets Equities and Commodities, and we are mindful that these assets are taking the brunt of the strength in the US dollar.
Even though the timing of the move to tighten US rates has been under a great deal of scrutiny and market forecasts are pushing expectations further back, the reality is that the US dollar is likely to continue its bull market trend in any case. There is still, of course, uncertainty over the timing and pace of US monetary policy tightening but this hasn’t stopped the US dollar appreciation versus emerging markets assets, including Commodities.
Will: Last quarter, you commented that, “there remains a very strong strategic argument for having some exposure to Emerging Markets Equities in portfolios” (Preparing portfolios for volatility, Compass, Q3 2015). In the third quarter, mainland Chinese equities suffered their steepest equity decline in more than two decades. How did this sell-off impact your tactical underweight position and how have you changed this positioning across global emerging markets as a result?
Rupert: On a strategic view, Emerging Markets Equities continue to offer long-term structural attractiveness given the demographics, economic growth, and share of global GDP.
Tactically, we have been underweight Emerging Markets Equities since the early part of this year. Our view is that growth in the emerging markets is slowing from a high level whereas developed markets’ growth is improving from a low level. We believe that the direction of travel is more important than the actual level of growth; therefore, our preference for Developed Markets Equities has not changed. The US dollar bull market exacerbates the slowdown in the emerging markets and further supports our view to maintain a lower exposure to emerging markets than would normally be the case.
Excerpt from “Misplaced gloom”, In Focus, 24 July 2015
The themes playing out in the UK economy right now are emblematic of those in the wider developed world at the moment. There remain plenty of risks, not least the ever present ‘unknown unknowns’ where diversification across asset classes and geographies is still the best protection. Within such a diversified portfolio, we still recommend a strong leaning towards cash, where nominal values will remain stable. However, the most visible potential bumps in the road ahead relate to the approach of tighter monetary policy in the US and UK. The re-emergence of some inflation amidst that expected acceleration in growth in the second half of the year may well see bond yields move higher across the curve. Sudden jumps in yields may well see risk appetite suffer in other corners of capital markets. We still suspect that such bumps will be temporary in nature as we still see this economic cycle having some juice left for the private sector squeeze. This suggests that equity market returns across the developed world will still be dominated by continuing profits growth on a 12 month view, even if the tactical ride becomes significantly less comfortable for investors.