Converging on neutral
For much of last year, the signals from our asset allocation models were characterised by two main themes. First, across the board, bonds looked more attractive than stocks at the macro asset class level; second, among the equity markets, US and UK looked most overvalued with some European markets looking relatively attractive. Recently, there has been a marked convergence between signals, with most markets in the neutral zone and no great differential between bonds and equities.
There are various styles of asset allocation and when making decisions in this area it is important to decide exactly what you are trying to achieve. The distinction between what is tactical and what is strategic or ‘policy’ can get a little fuzzy. The time frame of the monthly indications for IPE at six to 12 months is pushing into the medium term rather than the short term, but is a reasonable forecasting timeframe.
We operate a systematic process, updated every trading day, which uses a set of fact-based econometric models, refined over a decade, to rank the relative attractiveness of stocks and bonds in more than 20 markets over two separate time horizons, three months and 12 months. The IPE timeframe of six to 12 months can therefore require a degree of interpolation between the two forecasts. Most of the time the differences between the two sets of forecasts are relatively minor, but on occasion there can be a marked difference.
Right now is one such occasion as far as the US equity markets are concerned. Having had a firmly negative signal for much of last year on both forecasting time frames, falling interest rates have brought the short-term attractiveness signal up to the neutral region. The one-year signal, however, remains in negative territory. This does not appear to be consonant with the optimists who hope that current problems for the US will be strictly temporary with normal service, that is continually rising markets, resumed in the second half.
The key difference between the short and medium-term forecast is the inclusion in the former of factors such as volatility and liquidity measures to complement the economic and value- based measures of the longer horizon. Our volatility work differentiates between “expected” and “unexpected” volatility, seeking to capture elements of sentiment in the market within a quantitative framework. Thus on a fundamental basis, our forecasts are still negative for the US, but for the near term that view is being modified by the shorter-term factors.
With continuous coverage of upwards of 40 markets and asset classes offering a reasonably large opportunity set, there is often a range of signals, across the spectrum from the top to bottom decile of attractiveness ranking. Unusually, at present, there is a remarkable homogeneity among the signals which are bunched around neutral, suggesting an abnormally low level of tactical opportunity between either the main asset classes or across markets.
This makes translation from our current forecasts to the IPE framework fairly transparent at present, although at times a regional view expressed for European equities in the survey as say, stable, may disguise the fact that there are sharply differential forecasts among the 11 markets covered.
The currency views we submit to the survey derive from our stand-alone currency process. Similar to our TAA approach, it is a systematic process, updated daily, using fundamental factors in econometric models to forecast currency returns. This works on a multivariate basis, comparing each currency with all others, rather than just in pairs. This approach has enabled us to be long both dollars and euro whilst being short yen and sterling. We have reduced our overall risk positions in the markets recently as we see more modest opportunities than last autumn. That said, we still hold strong views in certain currencies. The chart demonstrates our current attractiveness rankings of the currencies that we actively manage.
Despite the year-end reversal, our long-term indicators still show the euro to be undervalued and we remain confident that the euro will appreciate in the coming months. We also find the New Zealand dollar attractive, but this is derived primarily from its long- term valuation. Set against these overweight positions we are modestly underweight in sterling, the yen and the US dollar. This latter stance has been partly driven by the recent interest rate reductions in all these countries.
Bill Godsell is managing director at First Quadrant