Our Investment Committee meets on a quarterly basis to consider market conditions and the relative values of asset classes. Its views – looked at in more detail below – are then used to guide the strategies that are applied to each of our clients by their expert advisers, in accordance with their unique circumstances.
Investors generally are nervous to ‘leave the party’ in full flow but, one way or another, 2018 looks like being much more volatile than 2017. The new populist government in Italy may well attempt to run higher deficits bringing it into conflict with both the EU and the ECB. This has the makings of another crisis which, while it might lead to better euro governance long term, will cause short-term instabilities. Longer-term worries include increasing isolationism and nationalism in the US and England, and instability in regional hot spots such as North Korea and Syria. It is too early to predict whether the current ardour between Mr Trump and Mr Kim truly marks the beginning of a beautiful friendship.
What we do know is that we have relatively strong markets driven by relatively benign current conditions. These will not last forever so we believe that a cautious approach to risk is sensible for the long-term investor.
If you would like to discuss any of this, please do not hesitate to contact me or any of the Acuvest team.
Economic Performance & Outlook
2018 has provided a marked contrast to 2017 thus far, both politically and economically. While Trump rattled cages last year, markets basked in the prospect of tax cuts and job growth. It was also a year of growth in Europe – with Brexit the only spanner in the works – and much of Asia.
This year, Trump’s grandstanding has spooked markets and world politicians alike. Investor fears of tariff wars between the US and both China and the EU was one of the factors that drove markets 10 per cent down in February, although they have since recovered. Trump’s appointment of John Bolton as national security adviser has elevated concern, with Bolton a consistent advocate of bombing and regime change in both Pyongyang and Tehran.
More recently, volatility spiked with concerns over the election of a populist anti-EU government in Italy, while in the UK, the government remains frozen by its divisions on Brexit. What is emerging is that making a smooth transition to a future outside the EU is enormously complex. As we thought at the time, the Irish border situation is being used as the critical argument between a hard and soft Brexit. It does look as if the hard Brexiteers are losing but they will not go down without a fight.
The economic impacts of political destabilisation are already apparent in two key areas. First, the oil price has broken out from its trading range of the last five years, driven by political uncertainty in countries like Iran and Venezuela. And just as critical, the prospect of trade wars looms, triggered by greater focus on the downside of free trade and on economic nationalism.
Given this darkening of the political and economic picture, it seems surprising that markets overall have done little since the beginning of the year. Only US yields have risen to any degree.
This seems to be a reflection of the balance between short- and long-term market prospects. In the short term, we are seeing strong profits growth – particularly in the US but really across the board. Monetary policy outside the US remains loose, with no sign of emerging inflation pushing central banks to tighten policy more rapidly.
It seems likely that this tug of war between short-term delight and long-term risk could continue for some time. If this is so, then we may not see any major change in markets through 2018. However, we are long-term investors and must look beyond the current period. On balance, we think that increasing risk and a slowdown in the US economy will start to loom larger as the year goes on. Whether the slowdown is in 2019 or 2020, it is hard to imagine that markets will not suffer some correction in that period.
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, 05/06/2017 – 05/06/2018, total return, locally priced
Bonds have traded within a fairly narrow range over the past year, although credit spreads have tightened somewhat as investors continue to chase yield. Italian yields however remain elevated following the election of a populist government keen to boost spending and debt.
Yields remain low overall: 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.
Equity performance over past year
Source: MSCI standard core data, 05/06/2017 – 05/06/2018, local pricing
Markets in 2017 generally experienced low volatility and a high degree of short-term optimism, based on benign economic conditions and central bank stimulation. 2018 looks to be quite different, with markets appearing expensive on most measures – except relative to bonds – and vulnerable to shock.
Many investment managers believe however that there is more to go, particularly in the US, with a president intent on a policy of fiscal stimulation, aimed at its infrastructure problems and the lower end of the labour market.
Markets generally have approached or exceeded their earlier highs after the falls of 10 per cent in February.
Property values have been reasonably stable or rising – apart from in the UK since Brexit – with relatively high yields offsetting reduced economic confidence.
We continue to believe that property exposure is sensible, and the long-term outlook for European property appears sound, as markets recover from a period of rental weakness. The Irish commercial market, where some of our clients’ money is, has had a good run and may no longer offer excess returns in the short to medium term.
Commodity performance over past year against equities
Source: Bloomberg Commodity Index, MSCI ACWI equity index, priced in US dollars, total returns, 05/06/2017 –05/06/2018
Recent major price rises in oil and other forms of energy show a return to levels at which production economics are more balanced. As economies generally strengthen, it would be surprising if we did not see some broader recovery in commodities, even though we appear to remain more generally in a weak long-term cycle.
Hedge fund performance over past year against equities
Source: Credit Suisse Hedge Fund Index (priced monthly), MSCI ACWI equity index, priced in US dollars, total returns, 05/06/2017 – 05/06/2018
Absolute performance has been disappointing through 2016 and 2017 and fees remain high, but the diversifying qualities of hedge funds and their ability to generate alpha are more apparent with current levels of market volatility. Higher interest rates may also give better hedge fund opportunities.
Sharp movements in currencies over the past year have given some opportunities for gains (and losses). These funds continue to be a useful diversifier.
Global Tactical Asset Allocation Funds
Similar to other funds with absolute return targets, the returns of many GTAA funds have been disappointing in recent years relative to equities, bonds and – in many cases – their own return targets.
Funds with the ability to change asset allocations rapidly within a broad universe remain attractive however, particularly given increased levels of expected market volatility and currently high valuations of equities and particularly bonds. These funds also provide good diversification from the more traditional asset classes.
These are floating rate sub-investment grade instruments with a strong covenant and a term of between six and nine years. The premium return over cash rewards illiquidity and credit risks. The class offers another diversification.
Short-term interest rates remain low and sit 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 risk.
Portfolio Structure & 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 global tactical asset allocation funds, certain types of hedge funds and sub-investment-grade credit risk) and defensive (including bonds and cash).
- Within clients’ portfolios, we currently advocate an overweight position in GTAA funds, high yield bonds, commodities and property. Balancing this, we are underweight equities.
- In a low-return environment, keeping fees low is particularly important.
- In building a portfolio, getting exposure to the equity risk premium efficiently is key. Given its low cost and avoidance of manager risk, passive investing should be considered as a baseline against which to assess the best way to gain exposure. Acuvest does, however, recommend using active managers where we believe they can add value, for example by exploiting their skill or where markets are less efficient.
We had changed our position on currency hedging following the depreciation of up to 20 per cent in the euro versus the dollar. While some movement was to be expected, this was excessive and proved to be artificially high. This has now been largely reversed although we are not yet at levels where we recommend taking off the hedge.