Not a time to ‘set and forget’
Simon Doyle, Head of Multi-Asset and Fixed Income discusses how the global economy, valuations and the influence of zero/negative rates have contributed to a lack of clear direction in risk assets.
The recovery in risk assets that has occurred since mid- February has been significant and relatively consistent across risk assets. That said, for equity markets the recovery has only partially offset recent losses with the broader trend in equities sideways at best. In credit, the tightening in credit spreads has partially reversed the predominantly energy induced weakness albeit spreads remain well above their post GFC lows.
The lack of clear direction in risk assets reflects several factors:
Firstly, the global economy is both a negative and a positive. On the negative side – while the major economies are growing, growth rates are moderate, downside risks elevated and the lack of upward momentum means constrained corporate revenues against a background of rising wage costs. The positive, is that this means inflation remains moderate and an excuse for central banks to err on the side of either more stimulus (in the case of Europe, Japan, China and now Australia) or tentative tightening in the case of the US. This has been the lifeblood for investors for the last few years.
Secondly, valuations (generally) are not compelling. That’s not to say that there aren’t pockets of value (we’d argue Australian equities for example are amongst the more attractive equity markets), on balance valuations imply modest medium to long term return prospects (at best). Against the highly uncertain economic backdrop, one in which recession risk is only a weak data point or two away, equity markets would seem to offer insufficient prospective return to take significant risk in.
Thirdly, the influence of zero/negative rates in supporting asset prices generally has been pervasive. However, as the US Federal Reserve inch closer to another rate hike (on the back of continued reasonable US economic data and the steady rise in US core inflation), this important layer of support is incrementally being withdrawn. There is also growing debate in Europe and Japan that recent measures (including negative interest rates) have been counterproductive.
The critical question though is where to from here?
We have argued for some time that central bank policies – while perhaps necessary from a political and mandate perspective – have been a pervasive force in distorting both asset prices and risk. It is possible (indeed probable) that the limits of this distortion are being tested. That is arguably why equity markets peaked in price terms around a year ago – despite more QE (in the case of Europe and Japan), and a dovish Fed (in the case of the US). Given this, the risk around asset prices at present would seem asymmetric. Strong growth, that potentially encourages higher rates, or weaker growth that raises recession concerns, are both highly problematic scenarios. Even the ‘more of the same’ scenario, that keeps central banks on the stimulus path, is unlikely to propel market prices higher given the potential that the limits on the ability of QE to push up risk asset prices is being tested. The bull case for equities is strong, non-inflationary growth (reflected in decent profit growth). The key is non-inflationary (which requires big gains in productivity) otherwise the interest rate factor will get triggered. Current trends in productivity are not inspiring.
None of this is to say that if equities aren’t rising, they must be falling. Volatility within a sideways trend is possible – indeed probable (Japan in the 1990’s and the US in the 2000’s), but it does mean that a set and forget approach to portfolio construction will be problematic – particularly in the pursuit of achieving our targeted return.
We do agree with the proposition that from current levels medium / long run returns will be moderate (ie. the low return world proposition), however, we do not think this means we need to significantly lower our return target. It does mean though that the ‘set and forget’ approach of the typical balanced fund structure is unlikely to deliver. We expect that the benign trend in asset prices will be accompanied by pronounced cyclical volatility and managing / capturing return on the upswings and avoiding/minimizing exposure on the downside will be paramount.
Our positioning reflects this environment (and has for some time). Specifically: For the last 12 months our equity weight has remained relatively moderate at between 25 and 30%. We have been more active in high yield credit reflecting the volatility in credit spreads. We are currently around the middle of this range, but have been adding downside protection in the form of US S&P put options given low volatility (ie. cheap volatility) and high prices.
Cash – our preferred defensive proxy – has ranged from around 25 to 40%. We are currently towards the lower end of this range. In the context of the points made above, it is important to note the difference between the moderate adjustments to our exposure on the basis of the evident short run volatility and the more significant structurally low exposure to equities on the back of a mature expansion with (as described above) asymmetric risk.
In terms of changes to positioning during May, the most significant thing to note is, we took profits on the AUD put options, put in place in April following the bounce in the AUD to around $0.76. With the AUD retreating to $0.72 following the RBA rate cut and a shift in market expectations regarding the outlook for local rates (coupled with a growing likelihood of a US hike in June), banking some profit seemed prudent. We remain long FX, mainly the USD.
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