An Outlook on Asset Classes
Global equities had a torrid second quarter, more than reversing gains made earlier in the year. Positive economic news in June, including strong manufacturing numbers from China, India and the US, was overshadowed as investors became nervous over sovereign indebtedness, the capital adequacy of European banks and warnings that global growth may slow over coming months. In contrast to developed markets, emerging market equities marginally failed to hold onto initial gains amid a rise in market volatility.
Kevin Burrows, International Chief Investment Officer at Nedgroup Investments provides his views on the outlook for the various offshore asset classes.
Equity - Asset Allocation Implications:
For the first time since February 2009, equity investors pulled more money from stock and mixed- equity funds in the first week of June (-US$31.3bn) than they did from money market funds (-US$18.2bn), while continuing to pad the coffers of bond funds (+US$2.3bn).
According to Burrows, the recent sell-off has served to increase the attractiveness of global equities relative to bonds. He believes stock markets in the developed world will provide the best safe haven (on a currency hedged basis) as the impending G7 government debt crisis unfolds.
“The only problem is investor sentiment is not yet completely “bombed out” as a contrarian indicator and valuation measures do not look exceptionally undervalued,” says Burrows. “Moreover, the technical charts do not look healthy. That said, I would be looking to move to neutral from our current underweight stance on equities on any further weakness.”
Property - Asset Allocation Implications:
According to Burrows, the May sell-off in real estate investment trusts (REITS) and property shares has again widened the discounts to net asset values, especially in European REITS, making them more reasonably priced on a currency hedged basis. Moreover, he says the continued growth in Asia should lend support to their property valuations, although care must be taken in their rising interest rate environment and their government’s deliberate efforts to reign in inflation.
Despite capitalization rates that have already come in quite dramatically, Burrows believes the case for bricks and mortar property is improving as the inflationary scenario gains traction. He refers to London office supply in particular. “Office supply in London was greatly curtailed in the crisis and many 20 year leases from the early 90’s building boom are set to expire, prompting a scramble for newer, more attractive space.”
He adds that there is a risk of higher government bond yields, either from sovereign risk or necessary to stem inflation and/or protect currencies, which could further reduce the property yield spreads and negatively impact capitalization rates and therefore prices. However, Burrows believes this risk should be partially mitigated by the UK RPI (inflation) lease escalator clauses.
Bonds - Asset Allocation Implications:
Due to recent ‘flight to quality’ and the increasing threat of debt monetisation, Burrows is increasingly uneasy with holding G7 government bonds. Moreover, he asserts that if the European crisis is resolved and if global growth surprises to the upside, the flock to safety could abate and the Fed could turn more hawkish.
He expects European government bond markets to be under increasing pressure as the ECB loses credibility. “Within governments, strong fiscal discipline seems to be only found in the emerging markets. Credit exposure still justified with higher yielding bonds a better opportunity as the distinction blurs between sovereign and corporate risk.”
Cash & Currencies - Asset Allocation Implications:
With inflationary pressures subsiding in the G7, Burrows is confident that interest rates should remain low for a while. “Most of the greatly undervalued currencies remain in the emerging markets; local currency debt continues to be an attractive way to play this revaluation theme. However, a quick win on Chinese Yuan appreciation probably will not happen.”
He believes the dollar is again the world’s most stable and credible form of money, built on a coherent economic base and a 200-year history of political unity.
Asset Allocation Recommendations
Depending on the risk profile of the client, which would determine what their strategic or normal allocation should be, Burrows recommends being slightly underweight global equities and properties with a modest overweight in investment grade and emerging market bonds.
Given the increased volatility of the markets, he believes that alternatives and hedge funds do warrant a place in a portfolio to provide some measure of downside risk protection compared to stocks. Finally, he recommends that an investor keeps some cash handy as “dry powder” to allow opportunistic purchases of equities if the market selloff continues.
As a specific example, he recommends a balanced fund to be 47-½% in equities, 7-½% in property shares, 20% in government, emerging markets and corporate bonds, 15% in alternatives and 10% in cash.
