Asset class performance and outlook
The global economy has weakened again. While we anticipate that this represents no more than another mini-cycle, there is a risk the backslide becomes more serious, with a number of potential triggers including another eurozone crisis, a Chinese hard landing caused by a collapse in the property market, the untested nature of a withdrawal from quantitative easing, and economic fallout from the political tensions caused by the Ukrainian crisis.
The economic cycle is at different stages in different parts of the world. The US is performing well (apart from some recent weather-related weakness) and the UK has been surprisingly strong, led by rapid gains in the housing market. Japan’s economy benefitted in the first quarter from a mini-boom in consumer spending prior to a sales tax increase on 1 April, and is now suffering at the other side of it. The promised programme of economic reforms is due to kick in later this year and may provide some renewed stimulus. Meanwhile, the eurozone is still struggling to emerge from recession, prompting the European Central Bank to introduce radical measures earlier this month, including a negative deposit rate for banks, targeted support for lending and the hint that quantitative easing might follow.
China is slowing and it looks unlikely that the government will enact a stimulus package this time to try to stabilise it. Elsewhere amongst emerging markets, policy tightening to counter the capital outflows experienced over the winter has come to an end, but a heavy calendar of national elections this year increases the risk of market volatility.
Bond yields have moved sharply lower, particularly in the eurozone, reflecting a number of factors including central bank guidance, some weaker than expected economic data and politically motivated capital outflows from Russia. Credit spreads have narrowed further, particularly for eurozone peripheral bonds.
The indicators we focus on favour return-seeking assets over both the short and long term. Markets, however, remain abnormally sensitive to changes in central bank policy, and investors need to be alert to the risks falling out of this, combined with the other headwinds characterising the current environment. As a result, we continue to recommend that clients retain a cautious portfolio distribution.
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, 10/06/2013 – 10/06/2014, total return, locally priced
The German 10-year yield has been trending lower this year after rising in the run-up to the end of last year. This may reverse alongside other safe-haven yields as the positive effect from US quantitative easing is removed. Over the short term, there will remain greater downward pressure on German and other eurozone yields than on their US or UK counterparts, due to expectations that the ECB will accelerate its policy easing in contrast to the other two central banks.
At current levels, credit spreads for the peripheral eurozone look expensive and are vulnerable to widening in the event of any sign of euro tensions rising.
Corporate credit spreads have been more stable recently at a relatively low level, which we believe provides an insufficient cushion against a rise in underlying government bond yields when that eventually happens.
We are now in a potentially more volatile period for credit markets as investors weigh the likelihood and timing of a return to more standard monetary policy in the developed world. During this time, we advise clients with liability matching requirements to review the role of bonds in their portfolio carefully, and to ensure the type of bond mandate in place remains optimal.
Equities – Equity performance over past year
Source: MSCI standard core data, 10/06/2013 – 10/06/2014, total return index (gross), priced in US dollars
After recovering losses from January’s wobble, most equity markets have enjoyed strong positive performance. Profits have generally surpassed expectations, except in the eurozone, where they have been constrained by euro strength. Emerging markets have done well in 2014 following a torrid period of underperformance.
Investors have become more pessimistic generally about the outlook for global economic growth. They remain sensitized to the economic data likely to guide central bank thinking, which may cause short-term periods of counterintuitive equity market weakness at times when economic data is strong.
We advise clients to maintain a neutral exposure to equities (and to return-seeking assets overall) and to use periods of outperformance to rebalance back to neutral in view of the risks outlined above. We do not however foresee sufficient market weakness to justify a more extreme reduction in exposure.
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.
Commodities – Commodity performance over past year against equities
Source: Thomson Reuters/Jefferies CRB Global Commodity Equity Index, MSCI ACWI equity index, all priced in US dollars, total returns, 10/06/2013 – 10/06/2014
While returns from commodity funds lag somewhat those from equities, commodities have produced positive performance in 2014 and over the last 12 months. The major trend however is likely to 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). We retain a modest exposure for the diversification benefit.
Hedge funds – Hedge fund performance over past year against equities
Source: Credit Suisse Broad Hedge Fund Index (priced monthly), MSCI ACWI equity index, priced in US dollars, total returns, 10/06/2013 – 10/06/2014
Performance has remained positive for most types of hedge fund this year with lower market correlations creating trading opportunities.
Low volatility in currency markets this year has proved a challenging environment for these funds. Low interest rates and a flat yield curve at the short end have also continued to constrain currency managers. Although performance has deteriorated recently, these funds continue to be a useful diversifier.
Global Tactical Asset Allocation (GTAA) funds
These funds provide good diversification benefits because of their broader investment universe.
Short-term interest rates are low and are expected to remain so for at least another year. The ECB has said it will keep rates down until the economy improves and forward-rate pricing suggests the market does not now expect a rise until into 2016. We therefore advise clients to include yield-enhancing alternatives to cash in their portfolio mix where this can be done at acceptable risk.
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.
- The euro has been weaker in recent months in in response to guidance from the ECB that they are preparing to adopt further easing measures against the backdrop of slow growth and inflation remaining persistently below their medium-term target. The eurozone crisis is still lurking in the background and has the potential to resurface at some point, raising the prospect of accelerating euro weakness. History suggests that in periods of financial market stress, currency hedging can increase overall portfolio volatility. While we recognize the benefits of hedging in terms of lowering portfolio volatility in the long term, our advice is to remain unhedged until the euro crisis recedes further. We will review this should the euro further weaken significantly.