As we noted earlier this week, there is, as always, a lot going on in the world. And much of it directly affects the thinking of investors. At such times, we find it especially important to take a step back from the ‘noise’ and take a rather more considered look at where we are, reflect on how we got here and, of course, examine where we think we are going.
Our starting point is, as always, to look at the overall risk positioning of client portfolios. For us, this involves the relative weighting between what we regard as ‘lower risk’ assets and those we regard as ‘higher risk’ assets. At present, we are overweight lower risk and underweight higher risk. This is the result of the programme of de-risking which we began some 18 months ago. We began it because of our view that we are drawing closer to the end of the business cycle than the beginning. A view that we still hold.
In terms of our lower risk positions, we are primarily holding high quality, short dated bonds. These are, essentially, ‘cash plus’ and, as such, offer a genuine ‘safe haven’ but the reality is the returns are muted. However, this allocation is the area where the priority is on the return of capital – so safety and capital preservation matter more than making a return on capital for this part of the portfolios.
Turning to the higher risk assets, we have positions in equities, alternatives and gold. Taking the latter first, we do not, as we have observed before, view gold as a safe haven. But it does tend to offer a genuine protection tagainst collapsing equity markets. So does that mean we expect a collapse? No it doesn’t. That is why the position is small.
As regular readers will know, we had been expecting increased market volatility for some time as we are at the tail end of the business cycle and global liquidity conditions are tightening. It would be fair to say, however, that the recent sell-off in equities was considerably more severe than we expected. In our view it went too far too fast and looked overdone. The subsequent bounce seems reasonable and may even go a little further if fears over global growth ease further. That said, continued volatility is to be expected and any further recovery may well be followed by renewed weakness. As a result, we intend to stick with our sizeable underweight to equities for the time being rather than try and make a speculative ‘bet’ on any further near-term market rally.
International equity markets
In terms of our allocations around the world, we also intend to retain our existing positions for now. US equities continue to look relatively expensive and monetary policy should continue to be tightened faster in the US than elsewhere. We are comfortable with our underweight here which is more a result of the need to fund our overweight of emerging markets and thematic allocations rather than a negative view on the US. We are more cautious on European equities as growth continues to slow and the European Central Bank ended its asset buying programme in December. Longer term, we are wary of structural and political flaws and may look to reduce our allocation in due course.
Emerging market and Asian equities have outperformed in the last three months – reversing around half of their underperformance earlier in the year. This better performance reflected lower expectations of US interest rate rises, a weaker US dollar and less pessimism over the US-China trade conflict. Valuations are also cheap and we want to remain overweight. We accept that, in the next major market sell-off, emerging markets are likely to underperform as investors flee back to ‘safer’ markets. However, our exposure includes regions such as Vietnam, the Middle East and Africa. These are less correlated to mainstream markets and the long term demographic and growth stories are particularly compelling.
The UK and Brexit
And so to the elephant in the room – the UK. UK equities have underperformed significantly over the last year. The market looks cheap but the continuing uncertainty over Brexit and risk of ‘No Deal’ are to blame. The Government may have survived the No Confidence vote – the first of many if the media are to be believed – but nothing has really moved on yet. Those suffering from Brexit Fatigue are hankering for the halcyon days where the news actually varied from day to day.
If there is a Brexit deal, domestically focused UK equities can be expected to outperform significantly – both because of a re-rating of the UK market and a bounce in sterling – whilst the big, international companies might see a short term underperformence with the usual currency-oriented concerns. Conversely if there is ‘No Deal’, UK equities should underperform significantly as UK – particularly the more domestic mid cap – will sell off. In the circumstances, we are comfortable retaining our sizeable UK equity underweight. We do, though, plan to reduce our smaller and mid cap positions soon.
Speculating about Brexit is all the rage in the media so we do not plan to join in. Instead, we have examined closely the impact of deal/no deal outcomes on our actual portfolios. The results were surprisingly good. In either scenario we expect our diversified exposures to minimize any losses. Now, in fairness, they will also limit the upside but this is something we are willing to accept in such uncertain times. In addition, our assumptions may not be exactly what plays out. Either way, we feel confident that we have significantly mitigated the risks our clients face from Brexit.
A word on commercial property. Once again we have seen property fund managers shift their pricing to the disadvantage of investors. They’ve done it before and will, doubtless do it again. According to the fund groups, they may have to sell assets to manage liquidity and meet withdrawals. And guess what is to blame? Yes, Brexit of course. The reality is that putting highly illiquid assets into daily traded wrappers inevitably leads to liquidity issues. We do not see how property funds could be deemed suitable for private clients and we do not want to hold any for our clients.
With the global economy still growing, the opportunity for corporate profits to grow remains. This, in turn, implies that there is scope for further upward moves in equity markets. Having already seen such a strong bounce, though, such moves may be less than the most optimistic commentators expect. And there are bound to be both good and bad days ahead. So, yet again, we emphasise the importance of ensuring that the ‘eyes’ of desire for return are not bigger than the ‘stomach’ of appetite for risk.
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