We have reviewed our investment positions in light of this week’s market developments and found that the basic outlook remains constructive. Consequently, we maintain our overweight in equities. However, the recent events in China are likely to reinforce the existing relative weakness in emerging equities, and we decided to further reduce our exposure in this segment. The rise in US bond yields has gone too far in view, and we expect a countermove…
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Mikio Kumada, Global Strategist at LGT Capital Management
Revisiting recent events amid volatile markets
Financial markets have remained volatile in recent days, and are continuously monitoring market developments. In this context, it is worth taking a step back to revisit what has happened over the past few weeks. In its last two meetings on 22 May and 19 June, the US Federal Reserve’s Open Market Committee focused on the possibility of phasing out its quantitative easing program, under which it is buying $85 billion in Treasuries and mortgage-backed securities per month. The FOMC outlined necessary conditions for such an “exit”, or “tapering”. The second meeting produced a more detailed scenario, but did not suggest a reduced conditionality.
Many investors see risk of a premature Fed exit
Nevertheless, since the first FOMC meeting, some investors began to see a risk of an unconditional and/or premature Fed “exit”, driving long-term bond yields higher and interest rate-sensitive assets such as equities lower. The US dollar continued to strengthen against most currencies. Overall, markets continued to behave along these patterns since the most recent FOMC meeting, with the notable exception of Japanese equities, which have stabilized in recent days, eking out a small gain.
We reiterate our constructive medium-term view markets
Upon revisiting markets and recent events, we reiterate that we view these movements as part of a transitory phase that represents an ordinary “correction” in equity markets, and possibly a rather benign normalization of the long-term interest rate environment. Perhaps some investors had gotten too comfortable with the idea of perpetually declining (and/or very low) interest rates. Thus, the recent gain in 10-year US bond yields by one percentage point to 2.6%, for example, appears to have served as a rather sudden wake-up call, reminding investors that market forces, if left unchecked, would eventually demand higher bond yields (which are a function of economic growth, inflation expectations, and default risk). However, if the economic outlook plays out broadly as the Fed expects (and market indicators imply), the recent gains in long-term bond yields should bode well for stock markets over the medium-term. Previous Fed tightening periods in 1994 and 2004 caused some initial stock market turbulences, but were either followed a new or continued long-term bull market (see chart 1, page 2 in the pdf).
Increasing share of long-term government bonds, keeping equities at overweight
On the other hand, there are also signs that the recent gain in yields won’t be sustained. Both actual and expected inflation rates have been on the retreat in recent months, and Fed officials, including Chairman Ben Bernanke, have made clear that they would continue to provide stimulus if the economy does not gain traction. This would mean that the recent rise in yields will run out of steam soon, or even reverse. In fact, technical indicators suggest that US bonds are now oversold, ready for a short-term rebound. We therefore decided to increase the duration of our bond holdings – i.e. raise the share of long-term US government bonds relative to the allocation of shorter-term securities, which are less interest-rate sensitive. In equities, we retain our overweight as we expect US economic activity to either pick up, or “tapering fears” to wane if the data remains soft. Both scenarios should support equities. Lastly, in the past few days, China’s interbank market has again experienced a credit crunch, reviving concerns about the health of the world’s second-largest economy. However, it should be noted that China has gone through a number of such episodes since late 2010 – all of which were eventually stabilized, and none of which inflicted lasting damage to outside markets (chart 2, page 2 in the pdf). Still, recent events in China reaffirm the increasingly widespread investor preference for developed over emerging markets, and we decided to further reduce our exposure to equities in the latter segment.
Source: ETFWorld – LGT Capital Management
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