The economy is growing steadily in the US, bottoming in Europe and resurgent in Japan, but overall growth rates remain modest, and inflation is either receding or very low. Against this background, the risk of an undue monetary tightening is low, and we decided to further raise our equity allocation ….
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Mikio Kumada, Global Strategist at LGT Capital Management
by adding to positions in Japan at the expense of Asia Pacific. We also trimmed our fixed income quota by selling high yield debt, and kept the US dollar overweight.
Macroeconomic framework: a distant scent of “Goldilocks”
The US economy is growing steadily, but not strong enough to trigger a disruptive tightening by the Federal Reserve. The Eurozone shows tentative signs of a recovery, as fiscal austerity programs are being relaxed, and “Abenomics” has started to deliver some positive results in Japan. There is some controversy within the Fed with regards to when it should start scaling back its monthly bond purchases, as well as the European Central Bank about taking further unorthodox support measures for the euro area. At the same time, expected inflation indicators and actual inflation rates are receding and/or low. Thus, the overall growth outlook has improved somewhat relative to inflation risks, reminding some investors of “Goldilocks” – a benign economic scenario with decent growth and low inflation. On the other extreme of the spectrum, with confidence levels still subdued and most advanced economies facing structural challenges, we also keep our risk scenario of a deflationary recession, but see only a low probability of it actually materializing.
Equities: overall exposure increased by adding to positions in Japan
We decided to modestly raise our significant tactical overweight in equities by adding to positions in Japan, our second conviction market along with the US, and biggest overweight now. The underlying forces that are driving Japan’s bull market remain intact in our view, and Japan’s sharp correction since late May represented a healthy development, providing an opportunity to re-enter the market at somewhat lower levels. The next litmus test will be whether Prime Minister Shinzo Abe delivers on the promised structural reforms, and we expect his administration’s growth strategy to become clearer after the Upper House elections on 21 July.
US stocks remain overweight; Europe maintained at marginally above neutral
With regards to the US, we maintain our equity overweight. In our view, fears about a premature withdrawal of quantitative easing are unwarranted, though they offered a convenient excuse for profit-taking after a prolonged rally. Recent data on jobs and inflation do not suggest an imminent reduction of the Fed’s monthly bond purchases. That is not to say that QE will not be scaled back at some point, but that any such move would come on the back of increasing evidence of self-sustaining economic growth, which should ultimately outweigh concerns about rising interest rates. Meanwhile, overall corporate profits remain high, margins resilient, and balance sheets strong. We also maintain our marginally above-neutral positions in European stocks.
Asia-Pacific reduced to neutral; Emerging Markets allocation falls to underweight
At the same time, we have sold part of our Asia-Pacific exposure, reducing the region from an overweight to broadly neutral (the purchases in Japan were greater, resulting in a small increase of the total equity position). The allocation to emerging markets also dropped from near-neutral to underweight. That was result of continued underperformance, rather than actual selling of positions, and we decided not to buy back into that segment. Growth in the emerging world has been slowing for some time now, which has hurt commodity-producing countries. In addition, more recently, Japan’s reflation policies have started to add competitive pressure on some export-driven economies. China and some smaller countries continue to report high economic growth, but Brazil and Russia face stagflationary tendencies, and some of the other emerging countries have their own issues too, ranging from the twin deficits of India (fiscal and current account balances), to the headwinds hitting the export industry of Korea, Japan’s main competitor in Asia. A valuation case could be made for emerging markets at some point, but we would like to see some confirmation of a turnaround, such as reversing fund flows or a stabilization of relative performance patterns, before adding to our existing positions.
Fixed Income: sale of high yield bonds slightly outweighs purchase of hard currency EM bonds
Conversely to our equity position, we slightly increased our overall underweight in fixed income securities by selling high yield corporate debt. As part of fine-tuning the segment, we have also raised emerging market government bonds from underweight to near-neutral, with a clear preference for hard currency issues (i.e. USD), but that adjustment was not big enough to outweigh the cut in the high yield, resulting in a slight drop of the weight of the fixed income asset class as a whole.
High valuations and limited upside compared to equities
Corporate bonds were an ideal asset class in a scenario of “muddling through” the debt crisis, providing investors with stable interest income, as well as capital gains. However, the sharp decline in spreads, combined with other observations, such as the releveraging of balance sheets, had rendered these assets classes somewhat unattractive in our view, and we had already decided to take profits in both investment grade as well as high yield bonds earlier in the year.
From today’s standpoint, a normalization of monetary policy in the US would be detrimental to assets with so-called duration risk (sensitivity to changes in interest rates, which hurts debt securities with longer maturities), and we decided to further trim the tactical allocation to corporate bonds via the reduction of the high yield segment, preferring to seek risk exposure via equities, which offer bigger potential gains.
Regular government and inflation-linked bonds maintained at neutral
Regular government bonds and inflation-linked securities remain in near-neutral positions. In the short term, we see a potential for a partial reversal of recent losses, perhaps triggered by waning fears of QE withdrawal. In the medium to long term, however, there are few reasons to hold large positions in assets with negative real yields.
Alternative Investments: Buying back REITs and keeping Private Equity at overweight
The Real Estate Investment Trust segment was the equity sector that was most sensitive to the Fed tapering debate, as it was seen as an alternative to bonds by yield-seeking investors. However, we see the recent correction as an opportunity to modestly buy back into this segment, slightly increasing our exposure. Overall, REITs and Listed Private Equity investments are maintained at neutral and overweight, respectively, resulting in a slight overweight in alternative assets, which is consistent with our pro-risk positioning. Commodities and precious metals (gold) remain unchanged at neutral.
Currencies: US dollar remains overweight, euro preferred against Swiss franc
The US dollar’s strength has waned recently, but the US continues to offer more economic growth and/or its monetary cycle has reached a more advanced stage compared to other advanced economies. Thus, we keep our US dollar overweight. However, within Europe, we now have a moderate preference for the euro against the Swiss franc (we had already implemented this tactical shift after an ad-hoc decision in late May). The Swiss central bank has reaffirmed the possibility of further measures to undercut franc strength, and deflationary pressures persist in Switzerland. Last but not least, we continue to neither have, nor seek, exposure to the British pound and Japanese yen. We view the recent rebounds in both currencies as temporary.
Source: ETFWorld – LGT Capital Management
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