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.
In September, we predicted a slowdown, believing we had seen the best of the recovery and we raised a concern on overheating. Markets took fright in October, and most are lower now than at the start of the year by five to 10 per cent. So where to from here? We believe risks are increasing and we are concerned about the lack of scope for central banks to take action – read on for more detail.
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
Since the crash in 2008, economies have struggled. Governments and central banks have found it difficult over the past 10 years to manoeuvre economies back into a normal cycle, where peaks and troughs would be driven by underlying trend growth. This prolonged period of unsatisfactory economic performance has pushed interest rates extraordinarily low – and quite widely negative. While inflation has also been muted, the level of real interest rates experienced has been exceptionally low for a decade. In the last two or three years however, it does appear that economies have at last started to behave in a more typical fashion, responding to the huge amount of stimulus which we saw in the years following 2008.
This is most evident in the US, which reacted more quickly to the crisis than other developed economies, and which has enjoyed very strong economic growth over the past three or four years. The Fed has been able to raise rates to more normal levels, though these remain lower than usual in an economy experiencing super-normal growth.
The pattern elsewhere is less clear cut. Europe has fared better in the last three years, but the ECB has only just called time on quantitative easing, and interest rates remain at or close to zero. Japan shows a similar pattern. China has behaved more like the US, albeit on a slightly different time cycle.
The real problem is that, outside of the US, there is virtually no scope to stimulate as economic growth falters. This is a particular concern in Europe in the face of Brexit and the difficulties of Italy. Globally, trade tensions, weaker economic data and market volatility are weighting risk to the downside.
If this is indeed a typical cycle, we might expect US interest rates to peak in 2019. In Europe and Japan we may need another cycle at least before rates here become more normal; artificially low rates will be with us for some time to come.
Inflation could affect this picture but there is little sign of this outside the US. Slowing economies and weak commodity prices will act as a brake on any serious inflation.
Protracted cheap money has also created asset bubbles, with equity and property consistently appearing over-valued. It is perhaps paradoxical that the one market – the US – where interest rates have risen, has seen equity prices at high levels relative to others. If interest rates are not about to resume normality, what is likely to happen? We expect that swings in the US market may be greater than elsewhere in the next economic cycle.
Bond performance over past year
All bonds 10+ years, 14/12/2017 – 14/12/2018, local pricing
Italian government bonds have rallied over the past month after their populist-led government agreed to lower its deficit target for next year. US yields have fallen as interest rate reductions are expected into 2019.
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. Over the long term, interest rates are likely to rise, having been kept artificially low for the past decade, and we are seeing central banks ease up on this pressure. It is very hard however to predict over what time scale interest rates will rise to more normal levels. Our confidence that this must happen within a reasonable time scale is waning.
While bond yields may be slow to rise, we believe that there is not much scope for them to fall further.
Equity performance over past year
14/12/2017 – 14/12/2018, local pricing
The last quarter of 2018 has seen falls of up to 10 per cent, with a definite swing towards a perception of heightened risk. The US started the quarter from a higher base, so has suffered a smaller drop over the year as a whole.
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.
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
14/12/2017-14/12/2018, US dollars
2018 has been a dismal year for commodities, amidst investor worries that China will be hit by the trade fall-out with the US. Whether trade disagreements are resolved or not may significantly affect commodity prices, with China the largest consumer of most global commodities.
We retain a modest exposure for its diversification benefits.
Hedge fund performance over past year against equities
14/12/2017 – 14/12/2018, US dollars
Absolute performance has been disappointing through the past couple of years 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 hedge funds better 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
These funds can provide good diversification benefits because of their broader investment universe. However, we have been disappointed with the absolute performance from the asset class over the past number of years. We continue to closely monitor the universe of products available but remain cautious as to the ability of the asset class to produce the level of returns required over the long run. Yet with equities at current levels, we believe now is not the time for clients to reduce holdings in this space.
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 source of 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.