Asset Allocation: A Study in Contrasts

Too early to increase equity weighting: Inflation expectations for the coming quarters are fairly moderate due to high unemployment figures and low capacity utilisation, allowing the central banks to maintain their low interest rate policy. The expansionary monetary and fiscal policy is supporting the equity markets as well as the commodity and credit markets. A variety of leading indicators and corporate results already reflect these optimistic expectations, but thus far they have been ignored by investors.

The equity markets look attractively valued again following the recent correction. The chart shows the increasing relative attractiveness of equities and corporate bonds compared to government bonds. However, the sharp rise in market volatility is a reminder that caution is called for and the risk of a correction remains high. We feel it is too early to increase the equity weighting until the mood on the market brightens and there is greater confidence in the deficit-cutting measures that governments are taking.

Correction in government bonds likely: There are also some striking contrasts on the government bond markets. Many developing countries can currently boast healthy budgets and real growth, while the developed countries are struggling with very high government debt levels and increasing demographic imbalances. The combination of high debt levels and an ageing population is dangerous because this demographic imbalance will make reducing government debt difficult over the medium term. This is a problem not just for the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) that are currently in the headlines, but also for the other developed countries.

In spite of this growing risk, yields on US and German government bonds have hit historic lows as a result of panic buying. The chart shows that, given current interest rates, the risk/reward potential of government bonds has become highly asymmetrical. There is virtually no scope for yields on 2-year bonds to fall further, but there is plenty of scope for them to move up. Sooner or later the low yields on government bonds will have to rise to more normal levels. As a result we currently favour corporate bonds and see a high risk of a correction in government bonds.

We believe the risk that measures to tighten banking regulations and to reduce government deficits will nip the economic recovery in the bud is relatively low. Instead we expect the market to refocus on fundamentals, which should support the economic recovery and help to calm the political situation. If investors become less sceptical and gain confidence in the measures that the different governments have introduced, we will take this as an opportunity to increase our equity weighting.

Bonds: Core Eurozone Markets Remain Overweighted
Due to the considerable uncertainties in the eurozone, we prefer core markets such as France to peripheral countries like Spain and Portugal. An exception to this are the government bonds of some core countries, such as Germany, which look expensive from a tactical point of view. Selected corporate bonds offer attractive return potential.

Despite the improved global economic situation, the major industrial countries are not expected to raise interest rates for the time being. The future direction of the economy is too uncertain and the likely inflationary pressure too low. The story is different in Australia, where the RBA has raised its key interest rate to 4.5% in a number of steps over three quarters. As a result of these moves, the Australian central bank has already gone much of the way towards normalising its monetary policy. Canada and New Zealand cautiously began their interest rate hiking cycle in the second quarter, following Norway, which carried out its first rate increase in the first quarter of 2010. Because of its robust economic performance, Switzerland is likely to begin raising rates before the eurozone and the US. Globally, the steep yield curves have already anticipated a large part of the rate hiking cycle and we therefore expect longer-term interest rates to continue to move in a relatively narrow range.

Core eurozone markets favoured: The European Central Bank began buying government bonds of struggling peripheral eurozone countries in mid-May. The additional demand is intended to keep a lid on bond spreads and keep access to the market open for these countries. We expect the fiscal austerity measures and the labour market and welfare reforms in the euro area countries to bring the fiscal and euro crisis under control.

At the same time, the market is likely to remain uncertain about the viability of the peripheral countries’ budget deficits for some time. Our investment focus therefore remains on the core markets, although German government bonds are beginning to look expensive. Within the peripheral countries of the eurozone, we prefer Italy to Spain and Ireland to Portugal.

Assessment of the interest rate markets: The European fiscal crisis has also dominated the global bond markets and led investors to seek refuge in the safe haven of government bonds in the main markets. As a result, yields on most government bonds are at the low end of the trading range we have been expecting. From a tactical perspective, we consider a short duration position in the US dollar, British pound and Swiss franc to be appropriate.

After the correction in the second quarter of 2010, non-government bonds are more attractively valued than government bonds in the main markets and will offer solid return potential in the event that the market quietens down. At a sectoral level we continue to favour financials over industrials. At the individual financial institution level, however, it is important to analyse the institution’s geographic risk distribution and financing position and the subordination of the instrument in detail.

The “optimal” mix of government and non-government bonds in the economic cycle: Non-government bonds (e.g. corporate bonds, bonds from issuers in developing countries and high-yield bonds) are essential components of a portfolio and contribute positively to an optimal risk/return profile. However, these credit exposures (broadly defined) should not be left unchanged through the entire economic cycle. Both the proportion of these higher-risk bonds held and their composition should be adjusted regularly depending on the position in the economic cycle.

The world economy is currently probably in transition from a recession to a recovery phase. While government bonds and corporate bonds were the preferred bond segments in recent months, the focus is now shifting increasingly to high-yield and emerging-market bonds. At a corporate level this transition is also supported by attractive valuations, solid fundamentals, low default rates and the superior growth outlook in the developing countries. Corporate bonds from specific companies and industries or specific instruments (e.g. asset-backed securities) remain attractive, but their potential is relatively limited.

Equities: Bumpy Ride But Opportunities Remain Intact
After May’s correction the equity markets are now attractively valued again. Companies’ return on equity is at a relatively low level and therefore has considerable scope for recovery. Market volatility is likely to remain high.

Global equity markets continued to gain at the beginning of the second quarter and reached new highs for the year in mid-April. Increasing concerns about the creditworthiness of Greece and other southern European countries such as Spain, Portugal and Italy triggered a significant fall in prices. This was accompanied by a sharp increase in market volatility. In early May the European Council and the IMF agreed a EUR 750 billion rescue package for highly-indebted European Union countries, with the European Central Bank (ECB) providing support by purchasing government bonds and through its money market operations. However, this rescue operation brought only temporary relief to the equity markets.

Patchy second quarter: At the cut-off date for this publication, the euro had fallen by over 8% against the US dollar in the second quarter. Heavily indebted European countries experienced the greatest losses, in particular Greece (-30%), Spain (-11%) and Italy (-10%). The emerging markets, led by Peru, Chile and the Philippines, performed slightly better than the industrialised countries. At the sectoral level, the biggest losers were financials and commodities. Energy stocks were hit by the oil spill in the Gulf of Mexico and the associated uncertainty regarding its cost and impact on the oil industry. The best performances were recorded by investments in cyclical consumer goods and the defensive sectors of telecommunications, consumer goods and utilities.

Promising economic data: The latest economic data have mostly been positive. The ISM manufacturing report and the leading indicators for the US point to a continued expansion in the US economy. Global earnings growth of around 15% is expected in 2010 and 2011, with forecasts for Japan (7%) and the emerging markets (13%) below those for the US (23%) and Europe (21%).

After the correction in May, the global equity markets are now attractively valued again. Companies’ return on equity, which has moved in a range of 7% to 16% over the last 20 years, currently stands at 10% and therefore has significant potential for recovery. However, due to the continuing uncertainty associated with the high deficits and debt levels of a number of European countries and the fears of a slowdown in China, the markets may remain volatile. 

Alternative investments: Seize Opportunities Selectively
Commodities: The commodity markets continue to struggle with the whole issue of global growth, especially in the European economies. After the sharp correction in May, a lack of new impulses on the demand side has prevented the market from recapturing the positive underlying sentiment that prevailed in March and April.

However, overall market volatility is falling again. In general, the commodities markets have been significantly less volatile than other risky asset classes over the last three months. Within the commodity universe, segments with very high volatility, which includes the cyclical segments of oil and industrial metals, have seen the heaviest losses. Surprisingly, relatively quiet commodity markets such as grain and oilseeds also lost significantly more ground than the market as a whole.

The lower volatility reflects the general market view that we are entering a stable inventory cycle. While some submarkets, such as rubber, may experience physical deficits, overall there are sufficient reserves available to the world economy. We are favouring one such submarket, namely tropical products like cocoa and coffee. We also continue to see opportunities in the precious metals segment.

Hedge funds: After having dropped sharply since mid-February, volatility on the equity markets skyrocketed in late April as a result of the uncertainty surrounding the debt crisis in Europe. This environment favoured short-term trading strategies which were also able to profit from the significant moves in exchange rates. The second quarter proved to be challenging for equity hedge fund managers, especially for those who do not invest on a market-neutral basis. After starting off the year on a positive note, arbitrage fund managers were confronted in May with the first rise in credit spreads after a prolonged period of decline.

The equity markets are being pulled in opposing directions. While the economic data are solid, there is uncertainty surrounding the high level of government deficits and debt. In addition, interest rates have fallen sharply. Against this backdrop the upside potential for beta investors is limited for the rest of the year. We are therefore concentrating on market-neutral equity managers and flexible trading strategies, which should continue to benefit from higher market volatility.

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