July was another busy month for investors consisting of both upside and downside surprises on economic data, continued headlines and debate around the Fed’s intentions to reduce their monthly asset purchases (‘tapering’), and a strong increase of the volatility of interest rates. Just to illustrate this last point: 10-year Treasury rates experienced a 10-bp reversal intra-day following the Fed statement last Wednesday, rose again 13bps on Thursday on a strong global PMI data, only to reverse 14bp again on Friday to finish below 2,6% on a weaker than expected US Payroll report! The feeling in the market is that higher volatility on financial assets is likely to persist given the implications of each incoming economic report on the Fed’s intention to reduce their liquidity program.
Despite a more dovish than expected Fed statement last week, with a new emphasis on disinflation risks and rising mortgage rates, we continue to expect that the Fed will start tapering at the next FOMC meeting in September. The Fed however has done an excellent job at communicating to the market that monetary policy will remain accommodative for the foreseeable future (tapering is not tightening). This, combined with the realization that economic conditions are getting slowly better is fueling the outperformance of equities versus bonds (cf. the performance scorecard of different markets, see below), a trend which we believe will continue throughout 2013 and 2014.
Our positioning has not changed since our last update in July: we increased the equity allocation in our model portfolio to 40% when tapering talk started in May and have reduced our fixed income allocation accordingly. Equities continue to offer the best value proposition, are supported by improving fundamentals and there are still no signs of heavy positioning from market participants in the asset class.
Our Equity allocation is constructed on several highconviction ideas:
1) Almost 50% of our equity allocation remains concentrated on US defensive large-cap stocks with a focus on consumer goods. We find it too early to enter cyclical sectors as the manufacturing cycle has not recovered enough yet.
2) Overweight European stocks as Europe is pulling out of recession following 3 consecutive months of rising Euro PMI’s (Purchasing Managers Index). We expect European GDP to reach 1% by mid 2014.
3) We have a long position on US Banks as a play on further US housing market recovery. The Standard & Poor's/Case-Shiller index of 20 large U.S. cities, released last week, rose 2.4% from April and 12.2% from May 2012. We believe this trend could continue and that US house prices have 12-15% further upside.
4) We maintain a 25% allocation to selected EM-stocks which offer significant value, following the severe EM underperformance vs. DM, since the start of the year. Preference goes out to Chinese Telecom and Oil.
5) Long Japan equities hedged in USD as Abenomics is only in its infancy stage and will continue to spur economic growth through massive monetary stimulus.
As mentioned in our previous publications, we think that credit markets and bonds in general will have a difficult time adapting to this new world of lower liquidity from the US. Consequently, we refrain from investing in long duration, illiquid assets with little compensation for interest rate risk. Our fixed income allocation remains centered on short-duration high-yield bonds with an average BB-rating and 3-4 years maturity. Within the credit spectrum, we prefer European names over US names and tend to avoid EM-assets altogether, except for selected short-dated external debt EM issues which we are comfortable holding till maturity.
A high degree of volatility across financial markets is likely to persist throughout the summer as we transition into a ‘new normal’ of a less expansionary Fed. That is why a proper regional and sector selection strategy, combined with rigorous risk-management should remain the decisive factor for investment performance. As usual, don’t hesitate to contact us to discuss investment performance or financial markets more generally.