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Rapid response tactics

During the last couple of years, we have been developing its tactical asset allocation process and accompanying quantitative tools. We believe that securities may be inefficiently priced over shorter or longer periods. Competing investors, however, will sooner or later tend to bring prices in line with future cash flows and the associated risk of the individual asset classes.
Risk aversion has fallen since equity markets bottomed in March 2003. Credit spreads have been reduced dramatically and volatility has been trending downward. This is fully in line with our belief that economic recoveries are usually accompanied by a feel good factor, enticing investors to take on more risky exposures.
Emerging markets equities, lower rated corporate bonds and emerging markets debt have been among the most profitable asset classes during the past year. Is it time to reconsider these tactical exposures?
Our valuation measures still favour equities and emerging markets equities in particular. Equity markets have surged in the past year. Despite the high return on equities seen during the last year, our valuation model still provides a positive signal on equities relative to bonds underpinned by the rapidly improving economic conditions and high earnings growth. As this signal is supported by our expectations of a continued positive development in the global economy we continue to overweight equities, especially emerging markets equities.
The falling risk aversion during the last year has narrowed the credit spread between high yield and treasuries, the spread now being at its normal level for expansionary periods. We maintain our high yield overweight due to expectations of an attractive carry.
At this early stage of the business cycle, the risk of collecting carry seems limited as companies are very focused on improving cash flows and lowering financial gearing. Thus, the default rate seems to improve as one would expect at this stage of the cycle. Still, as credit spreads are quite narrow now we should be cautious about the potential downside implied by a re-widening of the spreads. Thus, we have chosen to scale down our overweight exposure.
First, our economic scenario must hold true. However, it is important to stress that our tactical exposures are based on a moderate economic recovery only. We expect continued not accelerating economic growth, which, in our opinion, is required to ensure a gradual decline rather than a collapse in earnings growth.

Second, uncertainty has increased again as to the timing of the first rate hike from the Federal Reserve. Our main concern is the effect of a monetary tightening when the time comes for the initial change from the very loose monetary policy stance in recent years. Abundant monetary supply diminishes risk aversion.
Overweighting equities (emerging markets in particular) and higher yielding bonds (emerging markets debt in particular) may prove vulnerable to the first tightening steps from the Fed, even in a situation where the European economy is still bumping along the bottom and a monetary easing from ECB may be in the offing. Compared with the most recent hiking period from February 1994 till February 1995, when the Fed funds rate was raised from 3% to 6%, the two worst performing asset classes were emerging markets equities and debt. Cash and high yield were the top performers. We therefore expect to scale down our exposures to these asset classes, as the time for a Fed hike is moving closer.
We are convinced that tactical asset allocation is an important contributor to excess returns in a balanced portfolio. During the past year, we have further added to the range of asset classes in our universe and analysed the possibilities of exploiting excess return opportunities. Among the results of this process, we currently prefer value to growth stocks, as value stocks are less sensitive to increasing interest rates and have higher cyclical volatility in earnings. We obtain a neutral stance on large/small cap.
Applying our research in pure overlay strategies is the most efficient way of adding value, using derivatives for almost all major asset classes or parts thereof. We have reached very convincing results in respect to adding value, applying strategies based on global, regional and country equity exposures, small/large cap, value/growth, investment grade/high yield and currencies. Most often one or more of these relationships will be inefficiently priced leaving the opportunity for excess return strategies within the tactical investment horizon.
Keld Lundberg Holm is head of asset allocation and risk management and Bo Sørensen is senior investment strategist at Danske Capital in Copenhagen

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