February 2013 - Too Early for the Great Rotation
The first month of the new year is in the bag, creating a handy checkpoint to see what part of our investment strategy is working, what is not; and what needs changing. One theme that stands out in the first few weeks of the year has been the strong outperformance of Global Equities (+4-5% since Jan 1st) vs. Corporate Bonds (overall flat since Jan 1st) and vs. Government bonds (-1%/-2%), which have had their worst start to the year since 2009. This move has led some commentators to forecast the start of structural outflows out of the fixed income asset class into the equity asset class (branded as ‘The Great Rotation’).
We agree that a switch from fixed income into equities likely makes sense from a medium-term value point of view and as we commented in our 2013 Outlook, we started end of last year to rotate some of our Bond allocation to the benefit of our Equity allocation. Our model portfolios are now generally invested for 50% in High Yield Bonds and 30-40% in High Dividend Yield Equities.
Before we would look to increase this rotation further, we need to see actual and significant upgrades in expectations for economic growth and company earnings. The recent selloff in corporate and government bonds are mostly resulting from fears of an early end to easy money. We find these fears premature and are comfortable to keep our longs in corporate bonds but with a strong preference for high-yield bonds, which contain much less interest rate risk compared to investment grade bonds. The increase we have seen in government rates (+0,4% in 10-year US Treasuries since November) has had a negative impact on high-grade debt which offers little compensation against further interest rate risk.
We stay with our long position in High Dividend Yielding Equities as it seems to be the asset class which offers the most value in terms of its risk premium, compared to others asset classes. Our Equity model portfolio is defensive in nature and yields an average 5% in dividend yield. We remain overweight the following sectors: Energy (predominantly through Oil companies), US Real-Estate (through REITs), Pharma and Consumer Goods.
Economic data releases over the past month, especially the positive surprises from the Global Manufacturing indicators, support the rebound in global growth we have been expecting. Q4 GDP in the US may have contracted by 0.1% but there seems to have been a large distortion in the data, driven by one-off spending decreases. Equally supportive has been the latest US reporting season, with an average 4,9% earnings beat from approximately 50% of the companies which have reported so far.
On the politics front however, the Fiscal Cliff may have been averted at the very last minute on December 31st, but the sequestration cuts are likely to kick in on March 1st, while the debt ceiling debate has been pushed back towards midApril. We will watch these political stand-offs closely as they may be associated with heightened volatility in the financial markets later in the year.
On the currency front, the strength of the Euro (+8% vs. the US Dollar since November 2012) has taken us by surprise as we felt that the economic situation in Europe should not warrant such a move. The main driver behind this rally has been the steady increase in European money market rates as European banks have announced a higher than expected repayment of the ultra-cheap ECB loans made in 2011 and 2012 (LTRO I and II) – even the Spanish banks have felt confident enough to repay the ECB in high volumes (€44bn in the first tranche!). This coincides with yields on Spanish government debt trading below 5% for the first time since Q1 2012.
In our view, continued Euro currency appreciation could start affecting the Euro area negatively, especially for those countries that are export-driven like Spain and Italy. We are staying away from entering the Euro at such elevated levels vs. the US Dollar and expect some consolidation.
Now more than ever, with global rates being so low and some valuations looking expensive, good name picking and rigorous risk management are essential.