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.
When we wrote last in June, most markets had moved little on a net basis during 2016. We pointed however to a number of factors which we thought could upset this stable picture – Brexit, a Trump presidency, worse trouble in the Arab world, a blow up in the China seas. One of these has since happened and the others have become more, rather than less, likely over the past three months.
Economic performance and outlook
As we anticipated, a Brexit vote has caused more problems for sterling than anything else. The fall in sterling, combined with the Bank of England’s actions, has reduced interest rates even further. Lower interest rates have led to an increased search for yield, with consequent rises in most equity markets. While there is recognition that – whatever form it takes – the prospect of Brexit will reduce economic activity, commodities and UK property values are thus far the only victims of this.
What we are seeing is an increasing recognition of the difficulties that an extended period of very low interest rates would pose for bodies which depend on asset returns for their prosperity. The obvious examples here are banks, life insurance companies and pension funds. The longer that central banks keep interest rates down, the worse this will get. Moreover, we appear to have reached a point where lowering interest rates further (except to compete with other economies by devaluing the currency) has very little effect on economic activity. Could we eventually see a broad G7 attempt to raise interest rates in concert, where this might be combined with offsetting fiscal expansion?
We could spend a lot of time theorising about these extraordinarily low interest rates without reaching any logical conclusion on the likely catalyst for change or insights into when this might occur. What we can say is that the risk/reward ratios seem all wrong and that investment in ‘safe’ government bonds at these levels seems a bad idea. Even credit risk margins have reduced in the recent past so there is little comfort there.
We do expect that bond yields will rise, albeit this may be over a five-year period rather than necessarily in 2016. We would expect that as bond yields do rise, they will act as an inhibitor on equity markets. Rises in company profitability are unlikely to offset this fully, so it is difficult to be bullish about markets generally.
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, 31/08/2015 – 31/08/2016, total return, locally priced
10-year yields have reduced everywhere since the Brexit vote, with very long-term yields also down. German 10-year bond yields are now negative for the first time, with little change in the spread against peripheral bonds.
Corporate credit spreads have also fallen in the hunt for return.
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.
Commodity performance over past year against equities
Source: Thomson Reuters Core Commodity CRB Index, MSCI ACWI equity index, priced in US dollars, total returns, 31/08/2015 – 31/08/2016
A sharp increase in commodity prices over the past six months has reversed the trend of the previous year, but we do not foresee a bull market 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 do currently however advocate a modest overweight exposure both for the diversification benefit and because price levels do not look challenging.
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, 31/08/2015 – 31/08/2016
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 been below par relative to equities for some time now.
Equity performance over past year
Source: MSCI standard core data, 31/08/2015 – 31/08/2016, local pricing
Markets generally have approached their earlier highs after the falls of 10 to 20 per cent in mid-2015 and again in early 2016. Currency movements have advantaged the euro investor over his dollar-based counterpart. 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.
Valuations again look stretched following the recent recovery from mid-February lows and we currently recommend clients maintain an underweight position.
Property values have been reasonably stable (apart from in post-referendum UK), with relatively high yields offsetting reduced economic confidence. We continue to believe that property exposure is sensible, and are recommending clients who are below target weight in property to move up to target.
We see the eurozone as the home market for Irish clients, rather than the more concentrated, more volatile, and often less liquid Irish market.
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 and nine years. The premium return over cash rewards illiquidity and credit risks. The class offers another diversification.
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. 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 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 global tactical asset allocation funds and certain types of hedge funds) 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 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. 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.