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.
Please find attached the views of the Committee, concluded at the most recent meeting in May 2015.
If you would like to discuss any of this, please do not hesitate to contact me or any of the Acuvest team.
The beginning of an era of rising yields? July 2015
Economic performance and outlook
This year has been a period of two contrasting quarters. The first quarter of 2015 was marked by major currency movements including a weakening euro, particularly relative to the dollar. This was a consequence of the ECB moves on quantitative easing, with heavy bond purchasing and lower interest rates. Equity markets were generally positive with weaker currency countries doing best. Bond yields fell to new all-time lows in many cases, with negative yields out as far as ten years.
It is no surprise that the second quarter has been quite different. Although there has been some currency volatility, overall there has been little change. More significantly, interest rates have risen, particularly as term lengthens. It is also notable that the increases in rates have occurred in very short bursts, suggesting that there are a lot of nervous investors in bond markets.
Euro denominated equity indices also had a strong first quarter, followed by a small drift downward, particularly in June. Over the first half, the MCSI rose by about 12%, with a rise of 14% in the first quarter being followed by a drop of 2% in the second quarter; the rise over the past year is nearly 25%. Changes in the S&P and FTSE indices have been much more modest, mainly because of the currency effect but also because markets in the US and UK have not been as strong as in other areas. Asian markets have had a wide spread of performance with the strong rise in China being driven by something other than normal economics.
The economic prospects for Europe look to be quite a lot better with lower interest rates and lower exchange rates providing a double stimulus. As we write, the spectre of a Greek default and exit from the euro has reduced somewhat – but we have not seen the end of this long running saga. Whatever happens, we have seen the difficulty of running a common currency across countries which are not fully tied together. The likelihood of a British exit from the EU must have risen in recent weeks.
When we last wrote in March, we said that negative interest rates could not be with us for very long. We were proved right more quickly than we might have expected with the sharp rise in longer term yields in the second quarter. We continue to believe that interest rates generally are unsustainably low but forecasting when they will rise is a hazardous business. It also seems likely that the rises may be in short, sharp bursts, rather like setbacks in equity markets when these occur.
There are widespread concerns that liquidity in sovereign bond markets has been much reduced by regulatory enforced withdrawal by market makers (the large investment banks). There are already indications of sharply higher volatility as a result of reduced liquidity. It doesn’t take much these days to produce sharp price swings. When the bear market in bonds does start, it could be made much worse by this lack of liquidity.
The reversal in bond yields has not really been reflected in equity markets, so that the relative attractiveness of equities is somewhat diminished. Current valuations do demand a continuation of rising profits which are unlikely to occur in a period of economic stagnation and very low bond yields. We would expect that, as bond yields do rise, they will act as an inhibitor on equity markets.
Politically, potential for crises remains. The election in the UK highlighted local divisions with a leftwing, nationalist and pro-European Scotland contrasted with an English vote which has swung to the right and towards isolation in Europe. In the eurozone, we are seeing a marked contrast between countries like Ireland and Spain who have gone through substantial fiscal reform, and those like France and Italy and, of course Greece, who have not. The Ukrainian situation has the potential to deteriorate, particularly if the Russian economy falls further into recession. The Middle East remains in crisis: while Iran and the US appear to be reaching some sort of rapprochement, much of the US Republican party is isolationist and the upcoming election may see backtracking from the constructive foreign policy of the current presidency. The biggest risk is the continuing growth of ungovernable states such as Libya, Somalia, Syria and Yemen, sprouting extreme terrorism which threatens the rest of the world.
Our general stance remains cautious on markets and maintains that, at some point over the short to medium term, we will see a sharp rise in bond yields and a lot of volatility in equity markets. Timing remains our ‘known unknown’ and patience will be a virtue – for those who can afford it.
Bond performance over past year
Source: Thompson Reuters, BD Benchmark 10 Year DS Govt. Index, IR Benchmark 10 Year DS Govt. Index, US Benchmark 10 Year DS Govt. Index, Barclays Euro AGG 7-10Y Corp. (E)
The last quarter has seen a reversal of the long term downward trend in bond yields which culminated in some ten year yields actually becoming negative. The German 10 year yield has risen again to around 0.8% having been briefly negative in March.
US ten year yields had dipped below 2% in February but have now risen to well above the 2% level again. Countries like the UK and Australia are in line with these. The Eurozone yields are generally moving in line with comparable countries elsewhere, albeit with some lag.
Corporate credit spreads remain at a low level, not having moved much in the last year. It is difficult to see much value at these levels.
High yield spreads rose slightly in the second half of 2014 but have narrowed somewhat since then. There appears to be somewhat better opportunity in this class. 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 continue to rise.
Equity performance over past year
Source: Thompson Reuters, MSCI EM – Price Index, MSCI USA – Price Index, MSCI Europe U$ – Price Index
There has been a sharp contrast in movements in indices over the past year, driven largely by the changes in currency. UK and US markets have moved slightly upwards but the euro indices are up by nearly 20%. Thus the experience of the euro investor has been very different from that of a dollar-based investor. In these circumstances, hedging has become far more important and we have been recommending that clients – who have benefitted from being unhedged – should now consider changing their stance. There is something of a contradiction in the relatively low bond yields and low currency values on offer in the eurozone at present.
Equities appear cheap relative to bonds, especially in the eurozone, but valuations remain stretched by most other measures – although this ‘stretching’ has eased a little in some of the principal markets over the past year.
The market has a sound long-term outlook, tempered by a poorer rental environment in the short term where there is localized economic weakness. We recommend clients who are below target weight to move up to target.
The Irish property market has recovered somewhat in the last year and yields – despite their falls – remain relatively attractive supporting an allocation as part of a diversified property holding.
Commodity performance over past year
Source: Thompson Reuters, MSCI AC World U$ – Price Index, Bloomberg- Commodity TR – Return IND. (OFCL)
Aggregate price indices have weakened over the past year with only industrial metals bucking the trend after under performing other commodities for a couple of years. The major trend may 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). However, we now see an opportunity at these levels to start to rebuild commodity exposure.
Hedge fund performance over past year against equities
Source: Thompson Reuters, HFRI Fund of Funds Composite – TOT Return IND, MSCI AC World U$ – Price Index
Hedge funds (at a total level) have continued to provide a slow but steady level of growth over the past 12 months, experiencing a slight pull-back, as most asset classes did during the peak of the Greek crisis in June. Thematic relative value, event driven and equity bases strategies have all performed positively to a greater or lesser extent, with global macro struggling somewhat (apart from energy based strategies).
Sharp movements in currencies in recent months have given some opportunities for gains (and losses). 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 are now 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 rate.
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.
We have changed our position on currency hedging because of the depreciation of up to 15 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 would recommend euro investors to be at least partially hedged at these levels.