Equity markets currently present a dilemma for asset allocators. On the one hand, corporate earnings are buoyant, political risk in the eurozone is diminishing and economies worldwide are in the first synchronised recovery since the turn of the decade.
These circumstances should favour an overweight position in economically sensitive assets such as equities, according to McPherson.
But on the other hand, there is the thorny issue of over-inflated valuations, which should act as a warning to the markets to exercise caution.
Psigma’s portfolios reflect McPherson’s concerns. They appear quite defensive with plenty of cash, following a recent bout of profit-taking that sought to refocus the fund on high-conviction assets and away from “la-la land” valuations.
McPherson says: “Valuations are high. They need to be validated by cheaper share prices or significant improvement in earnings. We are halfway through the US earnings season and numbers have been strong, but we would also like to see a pull-back in valuations.”
Citing the Vix market volatility index, which is at its lowest level in more than a decade, McPherson says investors have become complacent, that they are chasing the rally in equities and in doing so are ignoring very real risks.
Those risks are largely to be found in the US, he says, where the equity market rally may yet be derailed by rising interest rates.
McPherson says: “The US Federal Reserve is expected to raise rates in June but if its rhetoric becomes more hawkish, it would be a danger sign and maybe the point to move away from equity markets.”
But there are also lingering political risks in Europe. While Emmanuel Macron’s victory in the French presidential election in May undoubtedly diminished risk overall, the UK and German elections are still to come and the Brexit negotiations are looming.
McPherson says the markets will probably muddle through in the US and Europe, but equity market valuations should reflect these risks.
Look more closely, however, and the group’s portfolios also retain cyclical exposure. They are overweight in reflation sectors, such as emerging markets, emerging market bonds, technology and the more value-orientated parts of the market.
He says: “We are tilted to cyclical companies, and underweight defensive sectors and bond proxies. We are overweight financials, some banks but mostly insurance and financial services in Japan, Europe and the UK.”
The group also retains infrastructure assets, believing these will benefit from the reflationary shift.
In terms of geographic allocation, there is a strong overweight position in Japan and an underweight to the US.
McPherson says: “On every level, we believe the US is really expensive. Profit margins are maxed out and we are late cycle in terms of interest rates. In contrast, earnings are strong in Japan and have been good for around five years, but valuations are not expensive and profit margins still have room to grow.
Positioning for value
“The Central Bank of Japan is onside and its policies should be inflationary, which in turn should be bad for the currency. As such, we hedge the currency exposure. This position has started to come good now.”