Market Jitters – April 2016 Strategic Insights
Our Investment Committee meets on a quarterly basis to consider market conditions and the relative values of asset classes. Its considered views 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.
If you would like to discuss any of this, please do not hesitate to contact me or any of the Acuvest team.
Economic performance and outlook
When we last wrote in December, the balance of economic commentary was lightly tipped to the optimistic side. As ever, there were worries – Chinese growth, some emerging markets, Greek debt, continuing conflict in the Middle East – but nothing sufficient to cause major concern for markets. December itself was a reasonably benign month, with equity markets strong and the Fed raising interest rates as expected.
Given the sharp volatility in equity markets thus far in 2016, with markets dipping by 10 to 20 per cent in the first six weeks of the year, before returning to their starting levels, you would expect there to have been a dramatic change in economic expectations. In fact, while some weaker statistics emerged – including some from the US – these alone have not justified the jumpiness of market sentiment seen this year.
There does seem to be some sort of cycle of expectations. Since the crash of 2008/09, central banks have made heroic efforts to push economies back towards ‘normal’ growth. Periodically – as in early 2015 and again in recent weeks – these attempts seem to be working, and the prospect of rising interest rates and reduced central bank stimulation appears within grasp, until the market retreats to a more pessimistic baseline.
In many ways it is a futile exercise to try to predict the economic future. We can explain the past, but predicting the future is generally unproductive – we are as likely to be right as to be wrong. Economics of the past is a science; economics of future predictions is definitely an art.
What we can do however is assess whether the returns currently offered by markets accord with the risks we perceive. Are we being rewarded appropriately for putting capital at risk in particular assets?
If we start with bond yields, we are in strange territory. Throughout most of Europe and in Japan, real government bond yields are negative – as far out as 10 years in some countries. Historically, real 10-year yields have been of the order of one to two per cent, so the implication is that we are in for a period of very severe deflation. While we know that central banks will do their best to stop this, their method is to pump huge amounts of money into markets which, of course, depresses yields.
This seems an artificial situation, where the risk/reward ratios appear plain wrong. Although we don’t know when things will reverse, investment in ‘safe’ government bonds at these levels seems a bad idea.
In contrast to risk-free bonds, credit risk has grown over the last few months. As a result, there is some value where spreads have risen, although we would focus on relatively short duration. We continue to believe though that, as the basis of all bond markets, risk-free interest rates are unsustainably low.
We have been underweight equities for over a year at this stage, largely because we felt that markets were underestimating the possible risks which were around. When markets fell in the first few weeks of this year, the risk-return ratio improved sufficiently to make equities start appearing interesting to us again. We will be watching carefully for opportunities to invest over the coming months
Source: Merrill Lynch, Irish Governments 10+ yrs, German Governments 10+ yrs, EMU All Non-Sovereigns 10+yrs, US Governments 10+yrs, 23/03/2015 – 23/03/2016, total return, locally priced
Through the past year, we have seen risk-free bond yields rise sharply and then fall back gradually to earlier lows. German 10-year bond yields fell to near zero last March, rose to about one per cent mid-2015 and are now almost back to their all-time lows. UK and US yields behaved similarly, falling below two per cent last February then rising mid-year, and now back below two per cent.
Corporate credit spreads have risen quite a bit recently, reflecting increased risk perception. Opportunity appears to exist here, particularly with high yield.
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.
Over the long term, interest rates are likely to rise.
Source: Thomson Reuters/Jefferies CRB Global Commodity Equity Index, Bloomberg Commodity Index, MSCI ACWI equity index, priced in US dollars, total returns, 23/03/2015 – 23/03/2016
Aggregate price indices have weakened considerably over the past 18 months, with energy particularly in decline. The major trend should 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). We retain a modest exposure for the diversification benefit and given the very sharp falls.
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, 23/03/2015 – 23/03/2016
Hedge funds as a group have posted poor returns over the past year. Although market volatility is significantly lower than that for equities – due in part to lower liquidity – fees remain high and performance has only barely beaten that of equities in a negative market.
Short-term interest rates have continued to fall and are now either negative or barely positive everywhere in the eurozone. The ECB is under no pressure to increase rates. Investors should not be afraid to hold cash though – for example to fund an increase in equity or property exposure discussed above. We do continue to advise clients to include yield-enhancing alternatives to cash in their portfolios when this can be done at an acceptable risk.
Source: MSCI standard core data, 23/03/2015 – 23/03/2016, local pricing
There has been a sharp contrast in movements in indices over the past year, driven by changes in currency and by weakness in particular sectors such as banks. The experience of the euro investor has been better than that of a dollar-based investor, because of currency movements. In these circumstances, hedging has become far more important and we have been recommending that clients – who have benefitted from being unhedged – should consider changing their stance at this time.
Investors continue to be influenced on a day-to-day basis by central bank thinking, which in turn is assumed to be driven by economic data. However, reality does ultimately count and the relatively poor results season in the US has affected markets. While equities appear cheap relative to bonds (especially in the eurozone), valuations appear stretched by most other measures. However, this ‘stretching’ has eased a good deal over the past year and equities continue to look a better bet than bonds.
A sound long-term outlook is tempered by a weaker rental environment in the short term due to economic weakness. We recommend clients who are below target weight to move up to target. Property values have been reasonably stable, with relatively high yields offsetting reduced economic confidence. We continue to believe that property exposure is sensible.
Sharp movements in currencies in recent months have given some opportunities for gains (and losses). Avoiding the Swiss franc recoupling was a necessity. 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 to nine years. The premium return over cash rewards illiquidity and credit risks. The class offers another diversification.
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).
- 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 recommend however using active managers where we believe they can add value, for example by exploiting their skill or where markets are less efficient.
- We have changed our position on currency hedging over the past year because of the depreciation of up to 20 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 recommend euro investors to be at least partially hedged at these levels.