Braced for higher rates
Our asset allocation can be broken down into the three basic asset classes. We have a long-term, strategic allocation, which stands at 3% cash, 57% bonds and 40% equities. Our current allocation is more overweight in equities (45%), at the expense of bonds (52%). Cash is neutral at 3%. The benchmark for our equity portion is the MSCI World Index, for the bond portion of our portfolio it is a synthetic benchmark, consisting of 50% JP Morgan Government Bond Index and of 50% Euroland Effas Bond Index. Through this approach we have boosted the Euroland portion in the benchmark to gear the allocation more towards our home currency.
Equity markets began to emerge from a three-year slump in the spring of 2003, and indeed the whole of last year was dominated by investors’ resurgent appetite for risk. So-called high beta stocks, such as technology, materials and cyclical stocks in general, led the pack, while the defensive sectors (food, health care etc) lagged.
In 2004, this picture has changed. Fundamental data continue to be very strong, indeed in the final quarter of 2003, US stocks (as represented by the S&P 500) posted their strongest earnings growth in a decade. But it seems that equity prices, which rose smartly in 2003 and into January of this year, have discounted most of the positive fundamental data and are now focussing on other, external factors.
There is the price of oil for one thing. In early May, crude prices in New York jumped above $40 per barrel, the highest level since the first Gulf War 13 years ago. High oil prices have fuelled fears of inflation lately, and indeed the Federal Reserve has already indicated that it will not keep rates at current ultra-low levels (1%) indefinitely. So investors are bracing for higher rates, they have to live with high energy prices, and the news coming out of Iraq is also deeply disturbing. There is indeed some fear that the ongoing barrage of horrific images will take its toll on consumer confidence and indeed consumer spending, which still fuels two thirds of US growth.
Expectations of rising rates and a seemingly unstoppable oil price have hurt bond markets. In the US, 10-year Treasury yields hit a 2004 low of 3.68 % in mid-March, but have since climbed to 4.87 %. In Germany, 10-year Bund yields have risen from 3.84 % (March 25) to 4.36 %. So clearly investors are betting on rising rates, at least in the US, and have positioned their bond portfolios accordingly. It seems that the confluence of circumstances which has favoured bonds for much of the first quarter, such as fear of more terror attacks and expectations for continued ease in monetary policy in the US, has come to an end.
Our asset allocation for the second quarter has taken note of this fact and maintained a reduced bond portion of 52 % (against 57% benchmark). We continue to believe in the fundamentals for equities, however, which is why we have remained overweight in stocks (45 % against 40 % benchmark). Earnings growth continues to exceed expectations and the balance of upward to downward revisions in earnings estimates is still tipped in favour of upward revisions.
Within the equity portion of the portfolio, however, there has been a change in leadership. Last year’s star performers (technology and cyclicals in general) have been replaced by more defensive groups, such as food and energy. Oil stocks in particular have done well over recent weeks, as investors have come to the conclusion that (contrary to last year’s conviction) higher oil prices are here to stay, at least for a while.
In terms of our country allocation, we are overweight Japanese equities, as well as those of the emerging markets. This reflects the fact that we continue to believe in the opportunities presented by China and Asia in general. Strong economic growth, which in case of Japan finally seems to have spilled over into domestic sectors, and the re-emergence of demand for technology have helped the region in the past 12 months. We are also overweight Euroland equities, while we have a slight underweight in US stocks. This has to do with our continued belief that the euro will remain strong, mainly due to the large current account deficit the US continues to run.
Our conviction of ongoing fundamental strength in the euro is also reflected in the bond portion of our portfolio, where euro-denominated bonds form 92% of the total (vs just under 70% for the benchmark).
Monika Rosen is head of research in asset management at Bank Austria Creditanstalt in Vienna