Our recommended exposure in balanced portfolios or funds has changed recently. After being overweight equities versus fixed income our current optimal portfolio stands near its neutral position. Cash is still not present in our portfolio since we do not retain cash as an asset class but consider it as a part of the yield curve.
In terms of the construction of the total portfolio duration, we slightly overweight the US and Euroland constituents and underweight the Japanese segment. The total interest rate sensitivity of our portfolio is slightly higher than our benchmark.
The risk of a further bond market sell-off in the wake of tighter monetary policy seems remote. First, significant inflationary pressures are not yet present in the real economy, suggesting that a pre-emptive tightening but the Federal Reserve will be sufficient to keep inflation under control.
Second, the sharp rise of long term interest rates in the previous weeks has significantly improved the fundamental valuation of the US bond-market-to ‘fairly priced’ (if not ‘undervalued’) territory. Indeed current bond prices are consistent with long term inflation expectations of more than 2.5 % and a 25 to 50 basis points hike by the FOMC. Two months ago, bond prices were discounting future inflation at less than 2 % and did not factor in a possible tightening of monetary policy.
In the light of the correct (if not undervalued) valuation of the US bond market, we have kept our grade for the US fixed income market at neutral.
The grade for the dollar remains at -1, given the outlook for stronger economic growth in the Euro-zone and the prospect of a large current account deficit in the US. In Euroland we expect economic growth figures to improve. First, manufacturing output appears to be on the verge of a rebound, given that the reduction of excessive inventory levels is approaching its end and export orders are set to rebound sharply in line with the weaker euro and the global economic recovery. Fundamentals for further strong growth of domestic demand remain moreover in place. Employment continues to expand and fiscal policy is neutral to expansive.
With actual inflation levels of around 1% and the ECB likely to keep monetary policy on hold for the coming year, developments on the Euro-zone bond markets are likely to be determined by the evolution of the US bond market. Hence our decision to keep the grade for the Euro-zone bond market at neutral.
Japanese economic data suggest the economic contraction has been stop-ped but there is no sign of a substainable recovery of domestic demand. The prospect of new fiscal and monetary easing will weigh on the Japanese fixed income market and at the yen. Hence our decision to maintain their grades at -1 and -3 respectively. After being overweight equities versus fixed income over the last 12 months we reduced the overweighting and moved towards its neutral position.
However in terms of allocation we clearly slightly favour European equities over US equities.
Although the earnings of US equities were surprisingly strong in the US equity markets, we do not recommend building up relative over-weightings. We do not expect out-performance based upon high valuation levels and current levels of interest rates. Our earnings discount model suggests an unattractive risk premium.
Although European markets were disappointing up until now, we continue to believe that equity markets are on a long term bull trend and a relative over-weighting is an adequate strategy. Absolute and relative valuation levels are less demanding and risk premium is twice the US equivalent. Earnings momentum will also support market performance.
The sudden enthusiasm regarding Japanese equities is bizarre and besides momentum, we do not see any explanatory and determining factor advocating and overweight. Our grade remains neutral but the next move will be on the downside.
Hugo Lasat is managing director at Cordius Asset Management in Brussels