We currently have around E5bn in mixed portfolios, that is portfolios which contain both equities and bonds. The portfolios give us a mandate to allocate between equities and fixed income instruments. Our investment philosophy is very much characterised by a top-down approach.
Here, I will describe our current allocation strategy and the arguments behind it. We believe that equities will outperform bonds in the near future and we outline our arguments below.
Economic data are coming in according to the usual pattern, although a difference this time around is that employment has not picked up as quickly as in the past.
Real disposable income has risen in the US in the past two years. Furthermore, falling interest rates have led to rising house prices and household lending. This has resulted in spending continuing at a high rate despite weak payrolls and the fact that stock markets have been falling.
It could be said the trends are underpinned by three factors: growth, inflation and the labour market. Growth has been strong for a long time now while inflation and employment are only just starting to show signs of lifting as they would have done under normal circumstances! This has led to doubts as to the validity of the first factor – growth – but now that it has started to rise any doubts about growth have been dispelled and interest rates have risen. Looking ahead, we will probably see a continued rise in interest rates which does not favour fixed income investments.
In this environment, equity markets are supported by rising inflation, as long as prices rise at a modest pace. Research shows that an inflation rate of around 2% to 3% has been the best environment for corporate profits and good equity yields. Something which is becoming apparent is that the companies, especially in the US, have been able to increase the prices of their products: pricing power is back.
In the US, we have had the best company reports for a decade so why are the stock markets not rising? Is this a warning sign? The trend seems to be steered by fears of rate hikes and more recently by questions of what will happen in China and the implications of higher oil price.
Rising yields should in the short term prevent the stock market from rising even higher. There may be a bit left before the equity markets reassess rising rates from being a threat to confirmation that the recovery will continue and that we will thus have a good corporate climate to some time yet. Market psychology is very important in the short term: it can turn everything upside down. Even if the fundamentals and share values can tolerate higher interest rates, stock markets can fall anyway.
The strong growth we have seen, especially in China, has led to rising commodity prices. The most likely consequences of this are that producer prices will stay on a high level, leading to higher inflation or lower profit margins. The continuing terror threats and the Iraq conflict with leading politicians losing in popularity and credibility are factors lurking in the background where the consequences are very difficult to predict.
Increased productivity has contributed to keeping inflation at a low level and has enabled central banks to support growth with extremely low interest rates way into the recovery. This has pushed down risk premiums and interest rates which has benefited bonds, commodities, emerging and high yield debt. Thus shareholders have received their part of the pie and now it is the turn of employees. Rising employment leads to higher wage costs which will eat into productivity gains. Thus the will to invest will probably also marginally decrease.
So which side of the coin will come on top? In simple terms, this is a battle between rising interest rates and good company reports. Both the rise in interest rates and the Chinese tightening should have been expected. So why sell stock markets when it finally happens? We believe that interest rates still have some way to go on the upside which is not good for bond investments. But at the same time continued healthy profits should support the equity markets in the next few quarters. However, we will probably have to get used to lower yield rates on all types of assets in future. We consider it highly likely that interest rates will continue to rise and that stock markets will thus move sideways in a volatile market in the near future. In this environment, we prefer equities and short fixed income investments to bonds.
Greger Wahlstedt is head of asset allocation and fixed income at Handelsbanken Asset Management in Stockholm