The Legal & General Investment Management (LGIM) multi-index and multi-asset total return (MATR) teams have increased risk in their portfolios on the belief that the market cycle has further to run, while tapping into forestry as an inflation hedge.
Worries over inflation as well as fears around the property market in China on the back of the Evergrande saga led to a market correction at the end of the third quarter, and resulted in the LGIM multi-index and MATR teams becoming bearish.
However, LGIM multi-asset manager Andrzej Pioch (pictured left, above), who works in the multi-index team, and Christopher Teschmacher (pictured right, above), a fund manager in the MATR team, believe much of the bad news has been priced in and both are cautiously increasing risk.
They say three factors suggest the market is still in a mid-cycle phase: continued loose monetary policy; supportive fiscal policy; and the accumulation of wealth in people’s savings pots.
“Listening to central bankers, they’re likely to be cautious in terms of potential policy error if they taper too quickly or hike too soon,” says Pioch. “So, monetary policy is likely to be supportive for a while and fiscal policy is still very supportive.
“On top of that, we have excess savings accumulated during Covid. These three factors will support the economic cycle.”
Search for ‘equity laggards’
Despite the team’s multi-index label, Pioch says the equity allocation is more diversified than a traditional global index such as the FTSE, because it seeks out sector rather than country exposure.
Given their view on the cycle continuing, the multi-index and MATR teams believe the recovery trade still has legs and so continue to back ‘equity laggards’ in small cap and the European travel and leisure sectors.
On travel and leisure, Teschmacher says: “These sectors benefited hugely as the narrative around Covid improved, but since the hit of the Delta variant they had a period of flat performance. Now we see the narrative once again improving, restrictions being lifted, not just domestically but on international travel, and that’s helping the travel and leisure stocks.”
Focus has also shifted to other areas sensitive to the pandemic and recovery, one of which is US small caps.
“US small caps have been hit by things like the labour shortages, which is a function of Covid and the growing pains from the recovery,” says Teschmacher. “But where we still see sensitivity to Covid news – both positive and negative – they’re the areas we want to move into.”
Recovery play
The MATR fund is overweight Japanese equities, a sector that has been beaten up over the years but turned a corner last month with the change in prime minister. There has also been an uptick in vaccination rates across the country.
“That’s fuelled a recovery in Japanese stocks, which has worked well for our portfolio, but we’re still holding some of that overweight,” Teschmacher says.
As a play on the recovery, the MATR portfolio contains a basket of Japanese railway stocks. Teschmacher describes railways as an area still “deeply underwater” from pre-Covid levels but one that is set to recover as passenger volumes increase on the back of escalating vaccine rates.
The team also likes artificial intelligence (AI) stocks, which it accesses through L&G’s AI ETF, as a specific view on the broader technology theme.
Pioch adds the AI exposure is an example where having sector positions is helpful because it avoids the heavy tech concentration in certain country indices.
“Everyone has been talking about the high stock level concentration in indices like the S&P 500, but the same theme is developing in emerging Asia, where you have Asian tech names dominating the performance of the whole region,” he adds. “We have to be more open to the sectoral plays in the future, either as a tactical position or as a way to offset that heavy concentration within countries.”
Pioch says LGIM likes US tech but the concentration issue means it is never going to buy a Nasdaq future, for example, which is more concentrated than the S&P 500. “To have a diversified exposure to tech, we’d rather buy the AI ETF, which is an equally weighted portfolio of 50 companies linked directly to the same theme, but doesn’t make us reliant on a handful of names.”
‘It pays to be humble’
On inflation, Teschmacher says it pays to be humble because it is “a difficult beast to get your head round”, noting that in the decade prior to 2019, the collective miss on inflation forecasting by economists was “pretty large”.
As a result, the team likes to hold more structural positions that help managing inflation risks, one of which is forestry and timberland stocks.
“We earn a real yield from that which is inflation-linked,” he adds. “In the environment we’re in now with potential fears around inflation, that is a structural asset class we want to hold for the long term.”
But he warns of a potential trap with timber because some ETFs and indices purport to offer exposure, but often hold paper companies rather than those that actually own the land.
“We’ve scoured the universe and these are stocks from all over the world – Brazil, Norway – that give you large areas of forest land, and these companies are managing that land.”
Teschmacher works with LGIM’s stewardship team to engage with those companies to make sure they are meeting official standards on sustainable forestry.
The MATR and multi-index teams are also tapping into decarbonisation themes, such as battery technology, renewable generation and even renovation and construction. In some of the multi-index funds, Pioch structures a portfolio of thematic ETFs, including a clean energy and clean water ETF.
Building blocks
As the name suggests, Pioch’s multi-index team uses index funds and ETFs as building blocks for equities through either L&G index funds or derivatives, such as a future tracking a particular index. Within alternatives, however, it can make exceptions and forestry is one example where it holds a basket of timberland company stocks.
But Pioch says he often meets with clients who think index investing puts a limitation on what they can access. “It probably was the case 10 years ago, but right now, with the proliferation of index funds, we can implement a sophisticated asset allocation with just those index building blocks,” he counters.
On bonds, Teschmacher notes yields have risen in response to higher inflation and the MATR team has been underweight duration with outright shorts in US duration. But it has been moving more neutral on duration recently.
“We see the balance of risks for yields from here as being more asymmetric. And yields are priced much more fairly at the moment,” he adds.
In line with both teams’ penchant for adding to risk, they prefer equities over bonds. Teschmacher explains: “Credit spreads are very tight and there is a very asymmetric payout from here, so the gains you can eke out are small and not particularly exciting.”
As such, the multi-index range is underweight credit and, in MATR’s case, outright short, which is a position Teschmacher argues is not too expensive for portfolios when the downside risks from spread widening are significant.
An independent market
That said, Chinese bonds are a reasonable allocation in the MATR portfolios on the basis they are a good diversifier from other global bond markets.
Teschmacher says there has been monetary tightening and rate hikes in countries including the Czech Republic, Poland, New Zealand and, closer to home, the Bank of England is talking about an increase. But in China there is a move the other way with a likely easing of monetary policy.
“German bunds move more based on what’s going on in the US than Germany, whereas Chinese bonds are quite an independent market. It’s the same as Korean bonds, which we hold as well,” he says. “And with that potential of easing in China versus tightening in other parts of the world, we see that as a good bond to hold at the moment.”
This article first appeared in the November 2021 issue of Portfolio Adviser. Read more here.
