In the current environment of high market volatility, and with the economic outlook characterised by considerable uncertainty, we think investors are well advised to stay close to their benchmark asset allocations. There will be times when the rewards for taking active investment risk are more obvious than they are now.
The US Federal Reserve recently increased their short-term interest rate by 0.5% to 6.5% in response to indications of continuing strong economic growth and a build-up of inflationary pressures. The key question now is, ‘by how much further rates will have to climb?’. Many commentators are starting to suggest rates will have to rise sharply to slow economic growth back to a sustainable pace.
Recent data shows that the US economy is carrying considerable momentum, but there are a number of reasons to assess its slowdown. We believe the interest rate rises made by the Fed over the past year are feeding through to reduce economic activity, with higher bond yields compounding the effect. Furthermore, much of the recent strength in consumer spending, driven by the gains investors have been made from the stock market – the so-called ‘wealth effect’. Following the recent market volatility, these gains are much diminished and consumer confidence has fallen as a result.
We believe the Fed will only need to increase interest rates once more in this cycle, taking the Fed Funds rate to 6.75 or 7.0%. The economy should then be slowing enough to keep inflation under control. The Fed’s efforts will be aided by structural trends related to new technologies and by global competitive pressures. Together, these have helped bring inflation down to the current low levels, and these trends are still in place.
We view the current global economic outlook as highly uncertain; consequently our forecasts are more tentative than usual. Markets are likely to be volatile in the coming months as investors struggle to determine the path of US interest rates. During this time, share prices may not make much pro-gress. However, we believe the medium-term economic outlook is favourable and we have chosen to stay positive on global equities. Specifically, we do not expect a return to high rates of inflation. Once the outlook is clearer, the stock markets should be able to make gains. We view government bond yields in the major markets, with the exception of Japan, as being close to fair value. We are happy to recommend neutral allocations to bonds. Cash looks relatively unattractive.
While an increasing number of our UK-based pension fund clients are choosing their own asset allocation benchmarks, many continue to base their strategy on the average allocation amongst their peer group of funds. The average, or median fund allocation is shown in the table. We suggest holding an above average allocation of equities, a benchmark weighting in bonds and below average levels of cash. Lack of liquidity means we tend not to recommend property for this type of managed fund. With few strong signals to differentiate the major equity blocs, we have gone for fairly equal overweight positions in the US, European and Japanese markets. The high level of sterling means we are a little less optimistic on the prospects for the UK, while the uncertain economic outlook makes us reluctant to take an aggressive stance on the emerging markets in Asia and Latin America. Our current asset allocation for a mainstream, low risk pension portfolio is shown in the table beside the benchmark. The allocations may not be particularly exciting, but it is better to hold fire in times of uncertainty than to take unwarranted risks.
Alistair Byrne is head of Investment Strategy at Scottish Equitable Asset Management, in Edinburgh

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