Asset Allocation: waiting for policy normalisation

Central banks will have to be careful not to raise rates too quickly given debt levels remain elevated; as a result, we believe the times call for more caution when it comes to taking on risk than might otherwise be necessary were we in a period of more conventional monetary policy.

Central bank jitters

The health of the US economy is a key argument in favour of policy normalisation. In sharp contrast to the situation in Europe, there is jobs growth, consumer confidence is at a 14-month high1 and the housing market is recovering. Despite this show of strength from the world’s largest economy, central banks still remain nervous about the consequences of an interest rate rise. The Reserve Bank of New Zealand, for instance, currently forecasts 3-month rates for 2016 in a range of 3.5% to 7.25%.2While this example may be an extreme case, it does reflect sentiment in other central banks around the world. Whether it is the US Federal Reserve, the Bank of England or the European Central Bank, all of them appear to be anticipating a potentially volatile period for financial markets as they adapt to the start of a rising rate cycle. Yet the markets appear to be choosing to ignore the warnings from central bankers, believing instead that central banks have the necessary tools available to them to maintain stability. We would argue that the risk premia in certain asset classes, notably government bonds, do not offer adequate compensation for the uncertainty that lies ahead.

Cautious on government bonds

Government bonds, especially those issued by heavily indebted Western nations, are, in our view, largely overvalued. Significant selective opportunities continue to exist but the enormous one-way bet in this market is over. Our portfolio already reflects our more cautious bond view to the extent that we would not have to make any drastic changes should there be any turbulence in the markets. We believe the risk premia are more fairly reflected in areas of the market like Asian equities. Looking at emerging markets, we believe bonds in parts of Latin America, offer interesting opportunities. Despite the economic slowdown, you can find in Brazil, for instance, yields on certain bonds that went from 8% to 13% in the space of a few months as a result of the decision by Brazil’s central bank to raise its rates to fight inflation.

As for Western government bonds, we believe reasonable long term equilibrium yields would be some 100-200 basis points higher than current levels to reflect central bank inflation objectives and appropriate risk premia. In Europe, the situation remains very fragile and disinflation still appears to be the order of the day. As a consequence we would argue that French, Spanish and Italian bond yields seem very low given their risk/reward profile.

Japan: normalisation some way off

The Bank of Japan has also implemented aggressive monetary policy measures but it is likely to be the last of the major countries to embark on the route towards policy normalisation. Moreover, it is worth noting that Japan is one of the few developed countries to have achieved stock market gains driven by earnings growth and not , as in other developed markets, thanks to increases in PE valuations.

As for China, the country’s growth has been slowing much more significantly than the authorities would like to admit. We still believe though that China has the capacity to avoid a systemic credit crisis. Chinese stocks, as result, have looked attractive to us and we have been putting more money to work here because they offer what we believe is very significant value.

On the currency markets, we have held the view for some months now that both the euro and sterling appear overvalued against the US dollar. The British economy may well be in better shape than its European counterparts, but the long term drivers of growth are less robust than the US.

US small-caps appear overvalued

Yet the strength of the economic recovery in the US has driven valuations in some areas, notably among small-cap stocks, to levels that do not truly reflect the value of the businesses. For the last few months, it appears that that the companies that have the weakest earnings and revenues have been performing the best at the expense of firms delivering solid cashflows, robust revenues and predictable earnings streams. Investors seem more drawn to the exciting future potential being offered by biotech, social media and internet firms than to actual current earnings and cash flows . To our mind, this enthusiasm for such stocks appears unjustified, especially as in some areas there are few barriers to entry. We are positioned for a reversal in this trend to the benefit of large, cash flow positive, revenue-producing companies.