We remain pro-risk but given how asset prices have moved over the past 18 months, we have become more cautious.
We continue to look for an acceleration in global growth, led by stronger activity in the US and Europe. Global equity markets have continued their upward trend as volatility across many asset classes remains relatively low. The US continues to add to jobs at a rate of over 200,000 a month for the last three months. This backdrop of a healing global economic environment is broadly supportive of risk assets.
Whilst UK inflation has only recently met or exceeded target levels, actual wage inflation remains relatively low, continuing to squeeze labour markets. Meanwhile, in Europe, core and headline inflation are well below target, and there is little inflationary pressure in the economy.
Eventually, the ECB believes the lending figures will start to pick up. But right now it is painfully aware that the momentum in the economy has not been enough to offset the downward pressure on domestic prices from high unemployment and the stronger euro. The ECB surprised on the upside last week, while much of the news was priced into markets, the extent to which the ECB aims to address weak credit growth, the unanimity of the vote and the language embracing further possible measures were all significant.
Unquestionably, global coordinated central bank action has had a significant impact in bolstering risk assets in the last few years. Whilst policymakers remain committed to ensuring that the economic recovery will progress, this will prove to be an increasingly interesting dynamic as some policymakers begin to steer back towards more ‘normal’ conditions. Reliance on extraordinary monetary accommodation will decline as we progressively move away towards a period of greater divergence, with rates moving away from zero in the US and UK whilst policies remain very accommodative in Europe and Japan. Regional variations in the speed of normalisation clearly have implications for asset prices, with relative value decisions likely to assume greater significance.
In our view, we are close to the point of transition when markets will begin to focus on a change of monetary regime. Such a change in focus typically produces lower, more differentiated and more variable returns. It would be quite surprising if this regime transition can be executed without triggering increased volatility, and this expectation is increasingly likely to be reflected in reduced levels of portfolio risk.
Whilst equity valuations are no longer cheap versus their own history, on equity-only metrics they remain attractively valued relative to bonds.
Our equity allocations have remained dominated by the developed markets, principally Europe, where we see a compelling opportunity to add in developed market equity beta. While we believe that the US will be a key driver of global growth going forward, the US equity market has a limited appeal to income investors so we are looking into other parts of the capital structure for income, areas that will benefit from the continuing growth of corporate America and provide the portfolio with an attractive risk adjusted yield.
We remain cautious on emerging market equities. Worries remain about the trajectory of the Chinese economy, in addition to political uncertainty and cyclical headwinds elsewhere in EM partly due to unwinding of quantitative easing in the US, and a dollar that we expect to strengthen further. Admittedly, much of this is already reflected in lower valuations. However, we are finding pockets of opportunity. Within fixed income, we see little value in investment grade corporate bonds.
We remain positive on high yield bonds although our allocation is much reduced. Going forward, we do not see such double digit returns but are satisfied that we are being compensated by the coupon against the risk of default; defaults rates in the US have remained low by a number of measures; corporate America remains in robust health. Rising rates in the US remains at the fore of our fixed income positioning; our sensitivity to rising rates in the US is hedged at portfolio level and complemented by diversifying asset classes that illustrate very little duration.
We are actively reducing our allocation to European fixed income, an allocation invested in peripheral European Sovereign debt, namely Spain, Italy and Portugal. This sleeve has produced some of the strongest returns year to date as yields have compressed dramatically in this space.
While we believe there could still be further to go, we judge that we can allocate our risk into other asset classes and receive a more compelling risk adjusted yield.
Within emerging market fixed income, we are gradually increasing our allocation from lows of 2%. While we remain very cautions on this particular asset class, we believe that a lot of the risk has been priced in.
