Contrary to the expectations of many commentators, March was a month in which both of the main asset classes produced positive returns. Of course, there were disappointing areas within both equities and bonds, principally emerging markets which, together with commodities, posted losses for a second consecutive month.
Fixed Income
UK index-linked gilts headed the asset class return tables surging 4% over the month in response to the changed inflation remit in the recent budget. Elsewhere in fixed income, yields dropped sharply in most main government bond markets but with gilts and bunds outperforming treasuries. This not only reflected some safe-haven support following developments in Cyprus, but also further cuts to economic forecasts and growing expectations of a further round of UK QE and rate cuts in the EU. By far the highest returns came from Japanese JGBs, however, as markets priced in very aggressive monetary easing by the BOJ’s new leadership which, in addition to massively expanding its bond purchase programmes, is likely to extend maturity purchases beyond ten years. EU peripheral bond returns were generally modestly positive although yields trended a little higher in most countries.
Emerging market debt had another poor month, alongside most emerging markets assets, facing growing headwinds in a number of individual countries. Spreads backed up to over 300 basis points at which level interest may begin to return.
Riskier credits continued to outperform in most of the main corporate bond markets with strong demand seemingly overcoming concerns that all-time low yields and compressed spreads offer little if any value. UK investment grade outperformed and BBB yields fell below 4% for the first time ever. The financial repression-caused “search for yield” continues.
Equity Markets
Another decent month for global equities closed out an excellent quarter for investors, especially those UK-based, with the MSCI World (AC) index surging 14% in sterling terms. The breakdown in correlations continued during March with markets being driven increasingly by idiosyncratic rather than global developments. Equity markets were once again led by the US and Japan, where the monetary boost is greatest and the economies strongest, while other regions were modestly higher (the UK and EU) or down (Asia Pacific and emerging markets). Developments in Cyprus provided an example of declining correlations as EU banks slumped 11%, even as US banks jumped 4% and outperformed a rising US market, while VIX (a measure of volatility) barely budged.
Even though the US outperformed strongly on much better than expected economic news, in the process taking the S&P 500 to a new all-time high of 1,569 at month end, it is interesting to note that the near-4% index gain in March was led by the main “defensive” sectors. This was also true within the UK and EU and is perhaps indicative of a more careful, cautious approach to increasing equity exposure, driven by exceptionally low bond yields that are pushing investors towards the safer/higher yielding areas of the one asset class offering potentially decent returns. Q2 may prove tougher, however, as the US faces a potential “growth scare” and the defensive areas of the market are now by far the most expensive. Too far too fast? We shall see!
Commodities
Another good example of the breakdown in risk asset correlations is provided by the main commodity indices falling yet again in March and declining 2% over Q1 (UBS Bloomberg Commodity CMCI index), even as the S&P 500 returned nearly 11%. While a departure from past trends, this suggests more selectivity and rational analysis in differentiating between assets. Even correlations between individual commodities continued to decline.
Industrial metals weakened on disappointing newsflow from China and investors continue to be concerned by rising inventory levels, especially for copper. Crude oil prices moved in different directions with US WTI up and Brent down, squeezing the spread to its lowest since last July. In agriculture, grains fell sharply late in the month following a US government report revealing higher than expected stock levels, while planned plantings were the highest since 1936. Gold rallied a little during the worst of the Cyprus debacle but failed to retain support. In essence, interest in commodities as an asset class is diminishing and a number of high profile institutional investors have scaled back commodity allocation not helped, of course, by returns being negative for the past two years.
Currencies
Following substantial volatility in the prior month, the main currency trends in March were further gains for the dollar and a bounce in sterling. Futures positioning reached extremes in most major currencies with massive dollar longs and huge sterling and yen shorts, suggesting some reversion might be due. Many commentators believe the dollar rally will prove sustainable, however, with the yen sliding further on BOJ action, QE being reactivated in the near future in the UK, and the ECB could be forced into finding a “Plan B” that includes lower interest rates.
UK Commercial Property
While the downturn in UK commercial property values continued in February, many commentators are becoming increasingly convinced that the downturn in the cycle is bottoming out. Return forecasts are trending higher but this is principally due to a slowing of the upward drift in secondary asset yields with anecdotal reports suggesting valuation indices, such as IPD, are behind the curve. With such a weak domestic economy, however, no significant upturn in capital values is forecast but, in such an income short world, the clear advantage of the high yield on property is increasingly obvious.
Asset Allocation Trends
With regard to asset allocation, on a global scale there are few signs of any great rotation out of bonds but there is certainly a trickle into equities. In general, strategists have raised equity market and lowered bond yield “targets” following recent price trends. Thus most commentators continue to prefer equities to bonds over the medium term, although a more difficult immediate period ahead is anticipated for equities as the US may suffer another “growth” scare during Q2. Direct UK property investment is also becoming increasingly favoured given the sizeable and growing yield gap and possible turn in the cycle.
