The traditional equity-versus-bond decision in asset allocation is becoming too simplistic. The clear trend is towards greater diversification, particularly into non-traditional asset classes, together with a shift from relative return to total return investment.
In 2003, there were many opportunities for asset managers to generate positive investment returns. Given the major market moves in 2003, ‘identifying the winners and avoiding the losers’ during 2004 has become more problematic as the more obvious sources of potential outperformance have now gone. In addition, the consensus that 2004 will be a year of strong economic recovery, with a further quantum improvement in equities and poor bond market conditions, may be too simplistic.
Economic indicators, in the second half of 2003, revealed that the global economic recovery, led by the US, was gaining momentum. We expect the global economy to grow above trend in 2004, being led by the US and emerging markets. In the US, despite some degree of moderation in the rate of growth during the second half of 2004, as the effect of lower taxes comes to an end, we still expect growth 3.5-4.0% for the year. For emerging markets, we are forecasting GDP growth of 4.9%, due to stronger earnings growth.
Whilst Japan and Euroland are both out of recession, GDP growth in 2004 is anticipated to remain sluggish, with growth rates no better than 1.5%. In Euroland domestic consumption and investment remains weak, whilst in Japan monetary conditions are weak and the upturn in consumption is fading.
Against this backdrop, equity markets could now be in for a sustained period of stability or at best moderate gains. Asset allocation, therefore, needs to focus on sectors where risk / reward is attractive and investors need to avoid ‘chasing’ market movements. In equity markets, large cap sectors are now at least fair value and in certain cases cheap relative to mid and small cap. Within equities, one logical switch is to take profits on smaller cap exposure, switching into large cap/market leaders.
In addition, there is a powerful argument for an asset allocation switch into ‘dividend’ equities, comprising sectors and companies that pay high dividends backed by strong cash flows. Whereas 2003 saw outperformance by high beta sectors, we believe that the key investment theme in 2004 will be the reverse; a year of limited opportunity for capital gains, with income-generating assets expected to outperform.
Emerging market equities performed well last year and, given their favourable growth outlook, there is a strong case for maintaining or increasing emerging market exposure. The theme of production and services being increasingly transferred to emerging markets is likely to continue, particularly in Asia. Although there has been widespread debate over whether the Chinese economy is overheating, and also on the problems in the Chinese banking industry, the probability of a sustained Asian slowdown seems minor.
In fixed income, buying opportunities are likely to emerge later during 2004 in longer duration sectors as markets over-discount the recovery in growth and the upturn in inflation. In the interim, credit spreads should remain tight and although risk/ reward has clearly deteriorated, high yield exposures should be maintained in the short-term. However, there is currently little argument for running higher quality corporate bonds relative to government paper. Convertibles continue to offer an attractive risk/reward profile and should improve portfolio information ratios over the next one to two years.
In an environment of moderate equity returns and difficult bond market conditions, a number of hedge fund strategies should perform well. Within hedge fund sub-components, for instance, a long/short strategy should outperform other sectors such as macro, dedicated short and event driven funds. The argument for hedge fund diversification seems more powerful than private equity given the correlation between small cap valuations and private equity, together with the likely underperformance of small cap.
Other alternative asset classes with the potential to generate attractive returns include property and, in particular, selective commercial real estate markets that are expected to produce competitive returns. Commodity markets, where limited upside is still apparent, should additionally act as an inflation hedge due to their low correlations with other asset classes.
In summary, asset allocation in 2004 will become necessarily more complex. Overall, the major market moves in 2003 will dissipate over the next six to 12 months; with a number of asset classes showing no clear trend, and with frequent short-term trading traps. Therefore, an investment focus on income, lower market volatility and increased portfolio diversification is likely to be rewarded.
Robert Parker is vice-chairman at Credit Suisse Asset Management in London