Asset class performance and outlook
The global economy has picked up after last winter’s lull, but growth forecasts for the coming year have dipped over the past few months, with significantly diverging outlooks for different parts of the world.
Geopolitical tensions escalated over the summer, and European growth expectations have been hit by the Russian sanctions. In contrast, the US continues to perform well, with the all-important housing market regaining momentum. In the emerging market sector, the Chinese government is doing all it can to combat a slowdown without a big headline stimulus package. The economic outlook in Latin America has also worsened, partly due to weak demand for commodities. In other emerging markets however, there are more encouraging signs, particularly in India where the recent election produced a government that places much-needed economic reform high on its agenda.
Quantitative easing continues to be a major influence on markets. The Fed is now well through its programmed reduction in liquidity injections but neither it, nor the Bank of England, is giving any clear signal as to when they might start raising interest rates. Markets anticipate rates starting to rise in both the US and UK by next spring, but remain sensitive to comments from central bank officials. The untested nature of QE unwinding heightens the risk of policy error – potential consequences include either unanticipated high inflation or an early return to recession.
In the absence of any new adverse developments, the eurozone crisis has almost been forgotten by investors. This is evident in the peripheral countries’ sovereign spreads, which are back to their level before the crisis erupted in 2010 (but still higher than pre-Lehman). Nevertheless, none of the underlying causes have been properly addressed and the aura of calm is encouraging politicians to procrastinate. There are still potential flash points, particularly the ECB banking stress test results expected to be published later this year.
The indicators we focus on favour return-seeking assets over both the short and long term. By historical standards however, equities are relatively expensive and have enjoyed an unusually long period of price appreciation without a significant decline. As a result of this and the potential risks outlined above, we continue to recommend that clients retain a cautious portfolio distribution, with that caution increasing on further equity market strength.
Bonds – Bond performance over past year
The German 10-year yield has been trending lower this year after rising in the run-up to the end of last year. This may reverse alongside other safe-haven yields as the positive effect from US quantitative easing is removed. Over the short term, there will remain greater downward pressure on German and other eurozone yields than on their US or UK counterparts, due to expectations that the ECB will accelerate its policy easing in contrast to the other two central banks.
At current levels, credit spreads for the peripheral eurozone look expensive and are vulnerable to widening in the event of any sign of euro tensions rising.
Corporate credit spreads have been more stable recently at a relatively low level, which we believe provides an insufficient cushion against a rise in underlying government bond yields when that eventually happens.
We are now in a potentially more volatile period for credit markets as investors weigh the likelihood and timing of a return to more standard monetary policy in the developed world. During this time, we advise clients with liability-matching requirements to review the role of bonds in their portfolio carefully, and to ensure the type of bond mandate in place remains optimal.
Equities – Equity performance over past year
Markets generally did well over the summer with the trend interrupted at times by geopolitical events or by expectations that US interest rate rises will be brought forward. The eurozone markets have bucked this trend recently partly due to the Ukrainian crisis and the Russian sanctions. Emerging markets have continued to perform well and are ahead of other major markets in 2014 after a torrid period of underperformance.
Investors have become more pessimistic generally about the outlook for global economic growth. They remain sensitized to the economic data likely to guide central bank thinking, which may cause short-term periods of counterintuitive equity market weakness at times when economic data is strong.
We advise clients to consider banking some more of the strong gains made in equities over the past five-and-a-half years by going below the neutral range and maintaining the rebalancing discipline against this lower level.
The market has a sound long-term outlook, tempered by a poorer rental environment in the short term due to localized economic weakness. We recommend clients who are below target weight to move up to target.
Commodities – Commodity performance over past year against equities
Aggregate price indices have weakened over the summer with only industrial metals bucking the trend after underperforming other commodities for a couple of years. The major trend is likely to 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.
Hedge funds – Hedge fund performance over past year against equities
Performance has remained positive for most types of hedge fund this year with lower market correlations creating trading opportunities.
Low volatility in currency markets this year has proved a challenging environment for these funds. Low interest rates and a flat yield curve at the short end have also continued to constrain currency managers. Although performance has deteriorated recently, these funds continue to be a useful diversifier.
Global Tactical Asset Allocation (GTAA) funds
These funds provide good diversification benefits because of their broader investment universe.
Short-term interest rates have fallen further and German bonds carry a negative yield for maturities up to two years. The ECB has said it will keep rates down until the economy improves, and forward-rate pricing suggests the market does not now expect a rise until 2016 at the earliest. We therefore advise clients to include yield-enhancing alternatives to cash in their portfolio mix when this can be done at 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 GTAA, certain types of hedge funds) and defensive (including bonds and cash).
- We favour at least a core of the equity holding being passively managed. Standard market-cap-weighted indices, like the MSCI All Country World Index, dominate passive mandates but we advise also including some investments linked to new, more efficient indices. These alternative indices are designed to reduce the concentration risk and associated risks of traditional indices, and aim to deliver enhanced risk-adjusted returns in a passive manner.
- Acuvest recommends using a passive management style unless it is demonstrably clear that the extra costs involved in active management are likely to add value. For example we recommend using active managers for specialist mandates such as themed investments where managers have more opportunity to exploit their skill or markets are less efficient.
- The euro has been weakening in recent months in response to the ECB’s guidance on potential easing measures and the pace of weakening has accelerated. The eurozone crisis is still lurking in the background and has the potential to resurface at some point, causing further currency volatility. History suggests that in periods of financial market stress, currency hedging can increase overall portfolio volatility. While we recognize the benefits of hedging in terms of lowering portfolio volatility in the long term, our advice is to remain unhedged until the euro crisis recedes further. We will review this should the euro further weaken significantly.