Equities - down but not out
We believe in the added value or alpha-generating potential of tactical asset allocation (TAA). Our investment process is based on the conviction that securities may be priced inefficiently over shorter or longer periods, but competition among investors means that over time securities tend towards price levels that reflect their future cash flows and the associated risks. Deviations will expectedly be turned into reversions. This mean reversion perception is important in the interpretation of the quantitative indicators of our tactical asset allocation process.
Our TAA process is based on two elements. First, economic analysis encompassing fundamental scenarios and evaluation of key economic indicators, but also geopolitical risk, accounting issues etc. Second, a TAA model objectively quantifies current market valuation, sentiment and risk aversion. The indicators must have intuitively explanatory power and /or be based on acknowledged economic or financial theory and they must show significance in empirical tests. Based on pure and non-manipulable economic and financial market data, the indicators measure the current market sentiment. This, in turn, adds valuable information as to what extent expectations have already been discounted in securities valuation, which has proven an attractive disciplining tool in times of euphoria or panic.
The American consumer has been on a constant buying spree in the late 1990s and has apparently not yet lost faith in the future. Even though the savings ratio has increased slightly, the American consumer is still the single most important source of global final demand. Monetary policy easing and rallying housing prices have underpinned this development and counteracted the effect of markedly deteriorating equity markets. However, the strength is also a threat. We cannot expect the American consumer to further support an economic recovery and keeping up the good faith could be undermined by deteriorating labour market conditions.
At the same time corporate America has been undergoing a consolidation process. Investment plans have been scaled down, but investments in equipment and software seem to have passed the bottom. This is where the potential for rising demand can be found – and one important reason for not expecting a renewed recession.
Europe will not add significantly to the restoring of global growth and there seems to be nothing but lacklustre short-term prospects for the Japanese economy. We find the most likely scenario to be a global economic growth below long-term trends in the next couple of years. Inflation will not be an important topic, fiscal policy will be increasingly accommodating and monetary policy will be conducted to avoid mismanagement in light of the sluggish economic prospects.
We believe that another deterioration of growth prospects and the threat of deflation are now more likely than a recovery quickly turning into above-trend growth. This does not bode well for equity markets in the foreseeable future. However, the crucial point is to what extent the uncertainty has already been discounted in asset prices.
Risk aversion and consequently the price of risk has been increasing in the past couple of years. This is mirrored in high equity market volatility and credit spreads hovering at very high levels compared to recent decades. Viewing US treasuries as the risk-free asset, a number of variables indicate risk as being a fairly good bargain. The yield gap is at a 20-year low, credit spreads are at levels not seen since the recessions of 1973 and 1982 and the real return on the ‘risk-free’ treasuries is at a very low level. Current market conditions clearly mirror a flight-to-quality effect.
Expecting an economic recovery to slowly pick up, a drop in risk aversion and a ‘return from safe haven’ effect are highly probable. In spite of its pitfalls, yield gap analyses clearly indicate an attractive pricing on equities compared to treasuries. With a sub-trend growth outlook for the next few years, we reduce our expectations in respect of a quick mean reverting process.
According to our analyses the years ahead will present moderate equity returns. As this has largely been discounted in the valuation we slightly overweight equities in our balanced portfolios. We do not expect P/E-growth to carry the equity markets away as was experienced in the 1990s. We rather see the potential for restructuring and cost cutting improving corporate earnings.
A drop in risk aversion will benefit more risky assets which supports our moderately positive view on equities. At the same time, it points to the attractiveness of more risky fixed income assets such as corporate bonds and emerging market debt. Long-term mean-variance analysis shows that especially the lower rated range of the fixed income vehicles typically outperforms both equities and treasuries during the first stages of a recovery. In addition, these vehicles add attractive diversification to a balanced portfolio. Our analyses further support this, and we recommend overweight equity positions in emerging markets, Europe, small/ mid cap equities and lower rated credit products.
Keld Lundberg Holm is first vice president, asset allocation and risk management, at Danske Capital in Copenhagen