No room for error


At face value, July was a continuation of the recovery. Equities were driven higher with 80% of S&P 500 companies delivering Q2 earnings above expectation. But while the market finished the month just below record highs, it wasn’t all plain sailing with Delta variant fears and China regulatory clampdowns creating volatility and wide dispersion in returns across markets – especially in emerging markets.

All eyes on China

The main news came from China, with the Chinese Communist Party’s (CCP) almost laser-guided focus of reducing inequality and boosting demographics impacting markets. To the West, it appears as if the CCP’s three priorities of national security, common prosperity and stability will be achieved at the expense of everything else. Their latest regulatory move sent shockwaves across markets (at its most extreme it accounted for 1.5tn in losses as they forced the lucrative for-profit education sector to convert to not-for-profit entities. Education costs are a major expense for Chinese households with some estimates showing household education spending as high as 30% of incomes, with more than 60% of primary school students receiving additional tutoring outside of schools. By reducing the costs associated with education sector the CCP will improve wealth for the masses, and promote additional births due to lower costs associated with raising children – which will offset their ageing population.

Why have I dedicated so much space updating you on Chinese education policy? Because unforeseeable events like this underscore why we utilise valuation metrics within our investment process. Over long periods valuations are a strong predictor of returns, but over shorter periods their explanatory power is less compelling. Today’s almost perfectly priced high valuations tell us the limited degree of error that markets can stomach. Therefore, a reduction of risk by increasing diversification is warranted over even the shorter term. This need for diversification was apparent in July as emerging market equities fell 6.7% over the month despite positive returns in almost every other major asset class.

How we are diversified

It therefore makes sense that we should provide a refresher on what we hold in our ‘diversifiers’ bucket and why we’ve doubled its size over the past 18 months. While global equities provided positive returns during July, they trailed returns from investment grade credit, meaning our diversifiers bucket was a significant driver of returns over the month. The major components of the bucket are active strategies in the higher yielding Asian and Australian credit markets – as well as emerging market government bonds.

Broad commodities is another one of our allocations, and people following commodity markets will be aware of the ongoing supply dispute within OPEC+ between Saudi Arabia and the United Arab Emirates. During the month this dispute was resolved and a new agreement to increase production in 2022 was announced. Initially the market saw this increased supply as negative, but we took the opportunity to add (+1%) to our broad commodity position as we took the view that the agreement reinforces the longstanding resilience of OPEC+. Our timing proved fortuitous as the position rallied over 6% into month end.

July also saw the addition of a new strategy within the diversifiers bucket in European dividend futures (+1%). This position is designed to benefit from the combination of the ongoing European recovery, strong corporate balance sheets as well as the relaxing European regulatory environment with respect to returning cash to shareholders via dividends. While European equities are trading 10% higher than their pre-COVID peak, dividend futures remain more than 10% below their peak, offering a good opportunity for catch-up before the end of 2022 when our position expires. This position was funded by reducing global high yield which is now in its 8th percentile on a spread basis since 1994 – so the prudent approach is to reduce high yield exposure at these heightened valuations.

Portfolio adjustments

Other portfolio changes during the month were designed to add to positions where market volatility provided better entry points. We reduced our foreign currency exposure by buying the Australian dollar (AUD) against the Euro (EUR) as we see AUD weakness to be short lived driven by the current lockdowns. We also rotated some of our global equity exposure away from value towards more ‘quality growth’ factors which we believe will outperform due to an increasing focus on the stability of earnings.

What’s on the horizon?

In the immediate future we face not only questions about peak growth and peak earnings, but also a seasonally weak month in August. Market breadth within equities is falling (fewer stocks are making new highs), potentially signalling a weaker outlook for markets. The US Federal Reserve’s annual Jackson Hole Economic Symposium at the end of August could deliver a quicker pace of  monetary policy adjustment. The Delta variant continues to spread not only domestically (with much of Australia in lockdown designed to limit its spread) but also around the globe – even in countries with high vaccination rates where positive cases have risen dramatically.

Our low expected returns and the above factors are at the front of our minds as we remain patient to deploy additional risk. While we wait, we will continue to rotate our intra-buckets exposures to more compelling opportunities while ensuring ample portfolio liquidity to deploy to more attractive opportunities as they become available.

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