Inflation volatility is a concept we may all need to become very familiar with, and creative portfolio construction is looking like the order of the day.
Despite what those who are bearish on the equity markets might say, the bull run in equities over the past six years has not been driven by loose monetary policy alone.
One must concede that a low interest rate environment and Quantitative Easing have provided support for equities in recent years, but also not forget that the effect of the global economy recovering and the actions which have been taken by corporate management teams around the world.
Generally speaking, we see the recovery following the crisis as one we might rate as “BBBB” – boring, bumpy, below-par and brittle – but nonetheless economic growth has sufficed to stabilise risk asset markets. Equities have been further boosted by low borrowing costs, excess in the labour supply and moderate revenue growth, most obviously in the US but now elsewhere too.
Quantitative Easing is not the only reason or even the dominant factor driving gains in equity markets – despite the fact that some reach for this as a rather easy justification. We could take Japan as a classic example here: observers obsess over the hyperactive behaviour of the Bank of Japan while simultaneously ignoring the potent cocktail of initial widespread investor distrust, low valuations and vastly improving corporate fundamentals that has caused the market to double in just over two years.
We believe that equities look like one of the best asset classes for the next five years. Yet we have been puzzled to learn that some of our peers have opted to increase allocations to equities as their solution to the conundrum of low bond yields and income requirements.
The rationale here tends to be that some shares are offering healthy dividends and are a justifiable choice on the basis of their valuations compared to bonds. Such reasoning has acted to create another distortion and it is hard to doubt that the helping hand of central bankers has also driven the valuations of certain sectors too far; the comparative dividend yields on offer versus government bonds have made many share price valuations extremely expensive in our eyes.
Our view therefore chimes with that of renowned fund manager Neil Woodford, who recently said: “I think it is interesting that the theory that supported these stock names recently is that bond markets have gone up and therefore these equities are cheap because the yield on their bonds or the risk-free rate has fallen again. I think that is the economics of a mad house frankly”.
Psigma believes that simply buying defensive or income equities is no solution, since stretched valuations create their own downside risks. Despite this, analyses we have carried out show that some investment funds billed as “Cautious” now have around half their assets in equities, mostly in income strategies. For those who can tolerate the volatility, holding equities may well be the right approach over the long term, yet this is a significant risk that cautiously-orientated investors need to weigh carefully in light of their current asset allocation – particularly given the fact that we believe the value remaining in equity markets mostly lies in the unloved cyclical and recovery areas of the markets (where cautious investors typically fear to tread). In light of these considerations, our Cautious portfolios have a maximum equity weighting of 30% (currently standing at 24%) and feature a blend of several sectors and geographies as we hunt for both long-term value and defensive income.
One of the central tenets of our investment portfolio philosophy is to find long-term growth – and at the right price – in global equity markets. At present it is extremely difficult to source such opportunities, however, as we foresee muted economic growth and believe that the valuations for more secure growth companies have become rather rich as investors who have been forced into risk assets have sought succour in developed market equities.
That said, we are still seeing a reassuring amount of attractive opportunities for future gains in some emerging markets. Top of our favoured markets are China and India, which both promise healthy growth and where there are still some companies undervalued compared to their potential. Historically, emerging markets equities have automatically been regarded as higher risk than their developed counterparts, but here again we would call upon investors to employ simple logic: an investor’s real risk is in valuations and if you buy something that is expensive then you have no safety buffer if markets take a turn for the worse.
With that in mind, we actually see the US market as representing higher risk than several emerging markets, purely because valuations are much dearer generally while earnings growth is looking subdued for the next twelve months at least. Furthermore, investors are currently enamoured by markets like the US while they distrust and shun emerging markets equities. We would advise cautious investors that if they want to enjoy healthy, inflation-beating returns in the next five years then they must have exposure to the growth engines of the world.
We are facing a highly-unusual investment environment and our portfolios reflect our view that the future is likely to be as uncertain for investors as it has been in decades. Speculation abounds, but nobody can predict where growth is heading with any certainty, how inflation will turn out or how long central bank meddling will persist.
Against this backdrop, investors – and particularly cautious ones – cannot afford to ignore bonds. Happily, some areas of the fixed income markets do still offer value, but investors will need to be highly selective and focus in our view on higher-yielding, shorter duration bonds since these can flourish in the coming years while default risks remain low. There are opportunities to make alpha in the US, UK and Europe, but as ever picking your manager and mandate carefully will be crucial to success.
The structure and focus of many traditional funds have given us cause for alarm and as such we have shifted the bulk of our bond allocations from mutual funds to segregated mandates. This is because we dislike the prospect of a run on fixed income funds at a time when corporate bond markets can be perilously illiquid. We also want to see a more concentrated, “credit-specific” focus from the managers we select for our clients, which leads us to question the sheer number of holdings in certain very large funds.
Perhaps most important of all, we have put efforts into creating mandates that create certainty as to duration. To explain further, standard bond funds compel fund managers to constantly reinvest proceeds from redeeming bonds, which keeps the fund’s duration long. Instead, we have worked with fund managers to structure funds that hold bond investments to maturity – which is the only way investors in bond funds really know what they are buying.
Rising interest rates and economic improvements may augur ill for many fixed income investments (which our fixed duration mandates seek to address), but these conditions are actually conducive for good returns from others. Here we would point to opportunities in European asset-backed securities and emerging market debt. The former are looking extremely compelling as yields appear very much healthier than those seen across segments of the European fixed interest markets. Futhermore, we are confident that these securities represent high quality and a low risk of default, along with floating rate coupons that rise in line with interest rates.
Looking to emerging market debt, here there is much to attract even the cautious investor. Firstly, the yields on offer in emerging markets are far higher than those from the (insanely overpriced) developed ones. In addition, emerging markets’ bonds stand to benefit from the cash-rich nature of many of these countries, as well as the interest rate cuts many of their central banks are putting in motion. Cautious investors may be wise to avoid the economic “enfants terribles” of Brazil and Russia, but investors focusing on high-quality emerging countries and companies with low levels of debt could do well indeed.
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