Economic performance and outlook

2015 has been marked thus far by major currency movements including a weakening euro, particularly relative to the dollar. This is a consequence of the ECB moves on quantitative easing, with heavy bond purchasing and lower interest rates. Although we have seen a significant retreat in recent weeks, 2015 has seen negative interest rates as far out as 10 years in some countries; even in Ireland this has extended to five years.

This background, aided by lower energy prices, has stimulated a significant rise in euro-denominated equity indices. Despite a sell-off in recent weeks, eurozone equity markets are up by 15 per cent so far in 2015 (1). The S&P and FTSE indices have seen far more modest increases (2), mainly because of the currency effect, but also because markets in the US and UK have been less strong than in other area.

We have therefore seen a rebalancing of growth prospects between those which were growing quite strongly – like the US – and those which were sluggish – like the eurozone. A side effect of these changes has been that rises in interest rates appear to have been postponed in the US and UK, where six months ago these had seemed imminent.

There has been a significant turn in bond markets since they reached all-time highs last month. Their behaviour during the first few days of May could well turn out to be just another temporary affair, a rise in yields that doesn’t last. But what if it is the much forecast start of the bond bear market? It is impossible to tell. When a more permanent reversal in yields does come, we now have a glimpse of what it will look like. And what it might mean for equities.

There are widespread concerns that liquidity in sovereign bond markets has been much reduced by regulatory enforced withdrawal by market makers (the large investment banks). There are already indications of sharply higher volatility as a result of reduced liquidity. It doesn’t take much these days to produce sharp price swings. When the bear market in bonds does start, it could be made much worse by this lack of liquidity.

As bond prices have been falling over recent weeks, so have equity markets. This is suggestive that as and when yields head higher, stock markets will inevitably suffer.

Politically, potential for crises remains. The election in the UK highlighted local divisions with a leftwing, nationalist and pro-European Scotland contrasted with an English vote which has swung to the right and towards isolation in Europe. In the eurozone, we are seeing a marked contrast between countries like Ireland and Spain who have gone through substantial fiscal reform, and those like France and Italy and, of course Greece, who have not. The Ukrainian situation has the potential to deteriorate, particularly if the Russian economy falls further into recession. The Middle East remains in crisis: while Iran and the US appear to be reaching some sort of rapprochement, much of the US Republican party is isolationist and the upcoming election may see backtracking from the constructive foreign policy of the current presidency. The biggest risk is the continuing growth of ungovernable states such as Libya, Somalia, Syria and Yemen, sprouting extreme terrorism which threatens the rest of the world.

Our general stance remains cautious on markets and maintains that, at some point over the short to medium term, we will see a sharp rise in bond yields and a lot of volatility in equity markets. Timing remains our ‘known unknown’ and patience will be a virtue – for those who can afford it.

Bonds

Bond performance over past year

Source: Merrill Lynch, Irish Governments 10+ yrs, German Governments 10+ yrs, EMU All Non-Sovereigns 10+yrs, US Governments 10+yrs, 13/05/2014 – 13/05/2015, total return, locally priced
Recent weeks have witnessed a sharp uptick in bond yields after they reached historically low levels during mid to end April. The German five-year yield currently hovers around zero, with the 10-year around 1 per cent. Peripheral eurozone spreads have continued to narrow.

US 10-year yields dipped below 2 per cent in February but have now risen above this level. Countries like the UK and Australia are in line with these. Eurozone yields are therefore out of line with comparable countries elsewhere – to a large extent the result of aggressive buying by the ECB..

Corporate credit spreads remain at a low level, having moved little in the last year, and it is difficult to see much value at current levels. We view some better opportunities in high yield bonds, with spreads having risen slightly in the second half of 2014 although they have narrowed somewhat since.

Where bonds are being used for matching and it is possible to take some risk, it seems sensible to either shorten duration or move into alternative investments.

Equities

Equity performance over past year

Source: MSCI standard core data, 13/05/2014 – 13/05/2015, local pricing
There has been a sharp contrast in movements in indices over the past year, driven largely by the changes in currency. UK and US markets have moved slightly upwards but the euro indices are up by 15 per cent. Thus the experience of the euro investor has been very different from that of a dollar-based investor. In these circumstances, hedging has become far more important and we have been recommending that clients – who have benefitted from being unhedged – should now consider changing their stance. There is something of a contradiction in the relatively low bond yields and low currency values on offer in the eurozone at present.

Equities appear cheap relative to bonds, especially in the eurozone, but valuations remain stretched by most other measures – although this ‘stretching’ has eased a little over the past year.

European Property

The market has a sound long-term outlook, tempered by a poorer rental environment in the short term due to localized economic weakness. We recommend clients who are below target weight to move up to target.

The Irish property market has recovered somewhat in the last year and yields remain relatively attractive supporting an allocation as part of a diversified property holding.

Commodities

Commodity performance over past year

Source: Thomson Reuters/Jefferies CRB Global Commodity Equity Index, MSCI ACWI equity index, all priced in US dollars, total returns, 13/05/2014 – 13/05/2015
Aggregate price indices have weakened over the past year with only industrial metals bucking the trend after underperforming other commodities for a couple of years. The major trend may still be downward for a variety of reasons: weaker demand due to lower (and less commodity-intensive) longer-term growth expectations for China, increased commodity supply and less interest in safe-haven investing (affecting precious metals). However, we now see an opportunity at these levels to start to rebuild commodity exposure.
Source: Credit Suisse Broad Hedge Fund Index (priced monthly), MSCI ACWI equity index, priced in US dollars, total returns, 13/05/2014 – 13/05/2015

Hedge funds

Hedge fund performance over past year against equities

After positive performance in 2014, this year has seen returns for a broad hedge fund index turn negative. However, many individual strategies continue to provide returns and reasonable diversification benefits.

Global Tactical Asset Allocation (GTAA) funds

These funds provide good diversification benefits because of their broader investment universe.

Currency funds

Sharp movements in currencies in recent months have given some opportunities for gains (and losses). These funds continue to be a useful diversifier.

Portfolio structure and risk management

  • It is very important that clients have a disciplined management framework for determining how to structure portfolios and how to adjust that dynamically over time.
  • Acuvest recommends that portfolios comprise a diversified mix of asset types which balances the desire for high returns with management of the associated risks. For this purpose, we group assets into three categories: growth (including equities and property), managed risk (including GTAA, certain types of hedge funds) and defensive (including bonds and cash).
  • We favour at least a core of the equity holding being passively managed. Standard market-cap-weighted indices, like the MSCI All Country World Index, dominate passive mandates but we advise also including some investments linked to new, more efficient indices. These alternative indices are designed to reduce the concentration risk and associated risks of traditional indices, and aim to deliver enhanced risk-adjusted returns in a passive manner.
  • Acuvest recommends using a passive management style unless it is demonstrably clear that the extra costs involved in active management are likely to add value. For example we recommend using active managers for specialist mandates such as themed investments where managers have more opportunity to exploit their skill or markets are less efficient.
  • We have changed our position on currency hedging because of the depreciation of up to 15 per cent in the euro versus the dollar and sterling. While some movement was to be expected, this is excessive and looks artificially high. On balance, we would recommend euro investors to be at least partially hedged at these levels.

Cash

Short-term interest rates are now either negative or barely positive everywhere in the eurozone. The ECB is under no pressure to increase rates even though economic prospects look better. We continue to advise clients to include yield-enhancing alternatives to cash in their portfolios when this can be done at an acceptable rate.

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