Equity markets seem likely to disappoint over the medium-term as history has shown that markets do not recover quickly in a lasting way from long or deep bear markets. Instead they are characterised by high volatility and a sideways evolution; the yearly performance of markets after protracted losses has been as high as +/-40%. This presents opportunities for tactical asset allocation, but does not hold out much hope for a broadbased uptrend. Moreover, it is not just history that weighs against an equity rally. Much of the recent US economic growth has been driven by tax cuts and the willingness of US homeowners to spend money gained from re-mortgaging their homes at lower interest rates. Once these stimuli run their course, longer-term problems (low savings rates, high indebtedness of both consumers and the corporate sectors, the output gap, and the budget and current account deficits) will begin to re-surface. Moreover, the earnings growth is bound to slow.
In the short-term the earnings season should be positive for the equity market as corporate profits are surging as the sector reaps the benefits of cost cutting and the policy-induced boost to growth. As a result, free cash flow is ample. This corporate restructuring means that in broad terms the corporate sector is now able to start spending again, and signs are emerging that it is now willing to do so. Later this year profit growth should fade. The turn in the labour market will dampen productivity gains and squeeze margins.
Although the prospects of the equity market in the medium-term are modest at best, in our view the balance of risk now weighs against bonds. Government bond yields are at historically low levels and are more likely to rise than to fall in the coming years. As a result we have an overweight position in equities.
Within our equity portfolio emerging markets are our long-term preferred region based on valuations, earnings expectations and structural improvements. In the current situation emerging markets could be the best of both worlds as they will outperform in case of a global economic recovery, will benefit from higher commodity prices and will benefit from global-outsourcing. Next to this, we think some local currencies are undervalued. On Japan we are also positive. Though the Japanese economy remains quite dependent on exports, we believe there is reason for optimism on the outlook for the domestic economy. For one, Japan’s employment conditions are beginning to improve. Furthermore households may also be gaining a measure of confidence from a stabilisation of their net wealth. The key factor here is emerging evidence that real estate prices are bottoming.
We are clearly underweight in the US and Europe. Fundamentals in the US still look good, but we see more growth potential in emerging markets. Equities in the US are already near all-time highs and valuations are rich. The European economy is clearly the laggard in the world and fiscal policy is not as supportive as in the other regions.
In this low return, high volatility environment, investors are seeking for extra return and diversification. As a result the flow of funds towards alternative asset classes looks promising. An extra risk premium or liquidity premium can be gained without altering the risk profile of the total portfolio as a result of diversification.
Where do we see attractive opportunities? High yield bonds is one of our favourite asset classes and is overweight in our portfolios. We are positive on corporate earnings and on balance sheet deleveraging. Both support improvement in terms of default rates. Although spreads have already contracted considerably, we still see potential as we expect the economic recovery will continue and spreads can decline even further if we look at it from a historical perspective. Next to this, flow of funds towards this asset class will remain healthy as investors are looking for additional yield. As a consequence, we have a small underweight position in investment grade bonds (only if we can also invest in high yield bonds) as we want to take the risk in lower rated corporate bonds as we see here more potential.
European real estate remains an overweight in our portfolios. In recent months we saw anecdotal evidence of some large institutional investors announcing a major shift in their strategical allocation towards this asset class. As a result inflows will remain quite strong. We also like European convertible bonds as an asset class. Some downside protection in a high volatility environment without losing upside potential is a very attractive quality. Next to this, the low implied volatility on equities gives more upside potential. The combination of a slack in supply and healthy inflows is also bullish. Other asset classes like small caps and emerging market debt are neutral in our portfolios. Valuation for European small caps have become somewhat rich compared to European large cap after the strong performance of this asset class and spreads for emerging market debt already tightened considerably and are quite low compared to history.
The overweights in the other asset classes are all at the expense of international government bonds as we assess this asset class as ‘most at risk’ as a result of an imminent threat of increasing interest rates. Not only economic growth, but also a pick up in inflation and other technical factors may push up yields in the near future.
How aggressive are we? Geopolitical incidents are on the forefront of every newspaper, highlighting the increased risks in the world. Although it’s hardly possible to take positions on this factor, we see it as a clear signal that we should only take modest tactical asset allocation positions in our portfolios.
Willem Klinjstra is analyst/portfolio constructor with Fortis Investments in Amsterdam