Stable disequilibrium – June 2016 Strategic Insights

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.

Our most recent meeting has been held at a time when, despite some short-term volatility, little has fundamentally changed in the key economic indicators. We considered what might cause a break out upwards in economic activity – and consequently interest rates and inflation. One possibility is a Reagan type expansion in the US under a Trump presidency. Another is a revolt by France, Spain and Italy against EU fiscal rules. We will be watching carefully for events and opportunities.

 

Economic performance and outlook

So far this year, most markets have moved little on a net basis. But this disguises some major volatility. Equity markets moved sharply downwards in the first six weeks of 2016, recovered those losses in the following weeks and more recently have traded sideways. Commodity markets fell in the first quarter, with oil dropping below 30 dollars a barrel. Again, these have recovered, with oil prices currently hovering around 50 dollars a barrel. Interest rates have generally drifted downwards near their long-term lows, although risk spreads have risen somewhat.

These moves are a reflection of market sentiment moving around a consensual centre which says:

  • Interest rates are too low and will eventually rise – but not significantly in the near future.
  • Equities are dear by most statistical measures but appear cheap relative to bonds.
  • Generally, economic activity is still well below optimum levels.

Volatility is caused by swings in sentiment as particular factors ebb and flow, for instance the prospect of rising US interest rates, Chinese internal debt issues, the likelihood of Brexit (although this is affecting sterling more than anything else) and refugees and rising nationalism, including the prospect of a Trump presidency.

While this year has seen a small uptick in US inflation, elsewhere this seems a more and more distant prospect as there is no evidence of pressure from labour, commodities, manufacturing bottlenecks or other areas. Deflation is exercising some minds and could become part of a vicious circle if the current growth scenario for the world economy deteriorates.

In our view there appears to be little on the short-term horizon which will make a huge change to the current scenario of slow growth, low inflation and easy monetary policies.

Bonds

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, 08/06/2015 – 08/06/2016, total return, locally priced

The past year has seen risk-free bond yields fall back to their all-time lows.

There has been little change in the spread of German yields versus other peripheral European nations’, while 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.

Commodities

Commodity performance over past year against equities
Source: Thomson Reuters Core Commodity CRB Index, MSCI ACWI equity index, priced in US dollars, total returns, 09/06/2015 – 09/06/2016

A sharp increase in commodity prices over the past three months has reversed an 18-month slide, 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 Funds

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 been on a par with equities in a negative market.

Cash

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.

Equities

Equity performance over past year
Source: MSCI standard core data, 08/06/2015 – 08/06/2016, local pricing

There has been a sharp contrast in index movements over the past year, driven by changes in currency and by weakness in particular sectors such as banks. Markets generally have dropped around 10 per cent from their highs, with the exception of the US, which has remained broadly flat. Worst hit have been emerging markets and Japan, where economic growth has been disappointing. 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.

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.

Valuations again look stretched following the recent recovery from mid-February lows and we currently recommend clients maintain an underweight position. Emerging market valuations remain attractive relative to developed markets.

European property

Property values have been reasonably stable, with relatively high yields offsetting reduced economic confidence. We continue to believe that property exposure is sensible, and see the eurozone as the home market for Irish clients, rather than the more concentrated, more volatile, and often less liquid Irish market.
We are recommending clients who are below target weight in property to move up to target.

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.

Valuations again look stretched following the recent recovery from mid-February lows and we currently recommend clients maintain an underweight position. Emerging market valuations remain attractive relative to developed markets.

Currency funds

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.

Senior loans

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 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, currency funds and hedge funds.
  • 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.

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