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.
Received wisdom is that bear markets only occur when there has been a serious change in the economic outlook. If this is the case, then it would be premature to say that this quarter’s upheavals are the beginnings of a major market reversal. But, having been concerned that markets have underestimated risk for some time now, we are cautious on the outlook for the next couple of years.
We’ve been having a look internally at exchange-traded funds, and whether these might be of use to our clients. For those interested in our thoughts, Click Here.
Economic Performance & Outlook
In December we looked back on the extraordinarily good year which 2017 had been for almost all forms of assets. But we warned that 2018 was unlikely to be as benign, and the year has already brought significant turbulence.
We have been underweight equities for over a year now, largely because we felt that markets were taking insufficient account of risk. Any losses seen in markets over the past couple of years have tended to be quickly recovered and markets overall remain expensive on most measures.
Which brings us to a dilemma: while we expect to see central banks starting to rein in economic stimulation and slowing markets down, there is currently little sign of this outside more cautious countries like Germany. The US in particular is running its economy as if it were in the bottom of a recession. When will this end, and what will happen when it does?
It is surprising that there has not been more discussion of the negative side effects of long-term quantitative easing. So far, focus has been on the dangers of stopping too early; it would be good if there was more thought of the risks of going on too long. Low interest rates have led to high asset prices, driving wealth inequalities between those who have – generally older people – and those who have not. Sustained low interest rates also have consequences for bodies which depend on asset returns for prosperity, like pension funds, banks and life insurance companies. The longer that central banks keep interest rates down, the worse this will get.
Pressure on inflation looks to be the only thing that will drive interest rates higher. There is some evidence that inflation may be on the up, at least in some countries such as the US – but the time scale is very uncertain and the level of rise is not likely to be large. A combination of rising energy prices and some labour shortages in key areas could change this.
If and when rates do rise, the reaction of markets is by no means a given. It is arguable that we have undergone a major shift in asset pricing led by the expected returns from long-dated government bonds because so many investors have been forced into matching assets with long-term liabilities. Until we see the effect of the unwinding of monetary easing, we will not know if this represents a long-term shift in expected returns. The answer to this will determine whether current markets – both bonds and equities – are fair value or wildly overvalued.
Taken overall, there have to be substantial risks in markets after such a prolonged period of upward movement. But predicting when there will be a break is not a rewarding exercise – it is sufficient to be cautious and to look for relative value where it exists.
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, 27/03/2017 – 27/03/2018, total return, locally priced
While German 10-year bonds have traded within a fairly narrow range over the past year, there has been some narrowing in the spread of peripheral yields, including in Italy following the recent elections. Inflationary concerns have driven a sell-off in almost all bond markets over the past couple of the months, particularly in the US.
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, 27/03/2017 – 27/03/2018, local pricing
Although turbulent, the major broad market indices show small single digit negative returns year to date, with some regions remaining in positive territory.
The medium-term experience of the euro investor had been better than that of a dollar-based investor, but this has now sharply reversed because of currency movements. In these circumstances, hedging has become far more important. Our recommendation that clients – who had benefitted from being unhedged – should consider changing their stance has proved worthwhile.
Markets remain expensive on most measures, except relative to bonds, and are vulnerable to any kind of shock.
We see the eurozone as the home market for Irish clients, rather than the more concentrated, more volatile, and often less liquid Irish market. The long-term outlook for European property appears sound, as markets recover from a period of rental weakness.
Commodity performance over past year against equities
Source: Bloomberg Commodity Index, MSCI ACWI equity index, priced in US dollars, total returns, 27/03/2017 –27/03/2018
Commodities are dominated by energy with the oil market having been extraordinarily volatile through 2016 and 2017. Recent 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 in a weak cycle.
We do not foresee any sharp upswings in commodity prices, but retain a modest overweight exposure for the diversification benefit and because price levels do not look challenging.
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, 27/03/2017 – 27/03/2018
Absolute performance has been disappointing through 2016 and 2017 and fees remain high.
The defensive qualities of hedge funds should be more evident however in a market reverse.
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
These funds provide good diversification benefits because of their broader investment universe.
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
- Within clients’ portfolios, we currently advocate an overweight position in GTAA funds, high yield bonds, commodities and property. Balancing this, we are underweight in 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.