Risk clouds equities
Asset allocation is often emphasised as the most important single decision in the investment process leading to a good result. For portfolio managers a good result, of course, is outperforming a benchmark.
As soon as the macroeconomic scenario is established, factors such as expected return on the different asset classes, expected correlation, which can differ from historic correlation, between the asset classes influence the final allocation. Valuation of the asset classes is central in this part of the process.
The big question in the financial markets is whether we will witness a double dip or sustained economic growth in the global economy in the years ahead. We believe that the US economy is recovering and will lead the global economy. At some point profits should start rising again. This will be the consequence of increasing demand and cost containment. Inflation is expected to be under control due to lack of pricing power in most industries.
The world has become more risky during the last year seen from an investor’s point of view. Most of the risk factors are not easily quantified. These include new terrorist attack on US and tensions surrounding Iraq with potential effects on energy prices.
Let us consider a stylised portfolio with a neutral allocation to traditional fixed income of 45%, equities of 45% and 10% to high yielding bonds.
The biggest beneficiary of the macroeconomic scenario should be high yielding bonds. Improved growth should increase the credit quality of this kind of bonds with spread narrowing as a consequence. Bonds from emerging markets have already had a good run in 2001 and so far this year, but current spreads offer a sound yield pickup. Corporate bonds have a great potential for narrowing of the yield spread from the present level. Therefore we overweight these bonds.
The correlation between high yielding bonds and traditional fixed income is expected to be negative. Mixing these two types of bonds therefore offers excellent diversification qualities.
Higher growth will lead to moderate higher inflation expectations and at some point the central banks in US and Europe will tighten monetary policy. These considerations lead to an underweight of traditional fixed income.
The valuation of equities is in general after our opinion fair. An overweight in equities is suggested to earn the equity premium. If the risk picture was more clear we would suggest a bigger allocation to equities.
Monetary tightening is already reflected in the short end of the yield curve. The yield curve is expected to flatten. Duration of the bond portfolio is recommended to be just below benchmark duration.
In the emerging markets we consider it as a rather safe to play the EU convergence play in eastern Europe. Russia is also one of our favourites. In the corporate markets we consider taking credit risk below benchmark risk.
You can consider equities from the Far East as a leveraged play on growth in the US economy. The higher return in this phase of the business cycle more than compensate for the higher risk in these equities. We overweight equities from the Far East.
The underweight elsewhere in the world will be the result of the regional allocation of the different sector bets. In general we prefer to be close to neutral in the different regions of the world. The active bets in the portfolio are taken in different sectors.
We believe that the general trend in earnings revision is upward, particularly in the TMT sector. This sector has been characterised by very low visibility. It might be a little too early to establish a full overweight in this sector and a gradual approach might be the right formula to benefit from the expected outperformance from this sector. As visibility returns to the market the pharmaceutical sector might be one of the sectors that will be hurt.
Niels Skovvart is chief investment officer of Sydinvest in Aabenraa, Denmark