Asset allocation: overweight global equities
After the euro summit about Greece on 12 July, things moved more quickly towards clarification. Declining uncertainty was seen as positive for risky assets. After having taken profits on our long duration position in core eurozone government bonds some time ago, we felt it time for an overall re-risking. Supporting this rationale was our expectation of better economic growth in the industrialised world and, even with a Fed rate hike likely later this year, a still accommodative monetary environment. We have thus gone overweight in global equities. The additional efforts by the Chinese authorities to stabilise China’s equity markets contributed to a much more positive market risk sentiment, which has been underlined by the subsequent sharp plunge in volatility.
This also supports the expressed earlier in our commentary on Chinese equities and our avoiding an underweight in emerging equities, because it is one of the few broad asset classes that, in our opinion, is still attractively valued. The outlook for growth is cloudy not just in China, but in numerous other countries. So we think it is too early to consider an overweight in emerging market equities on valuation grounds.
We prefer to be exposed to the attractive valuations of emerging equities via emerging Asia, which we believe offers good value and quality. Underlying earnings in Asia are on a par with developed companies’ earnings; monetary and fiscal policies are more supportive and we believe in the region’s reform progress. We are overweight Asian emerging equities versus broad emerging equities. Since we invest in MSCI indices, our exposure to Chinese domestic shares, which have made much larger moves than Chinese shares traded in Hong Kong, is limited. So we did not benefit on the upside, but we also did not suffer from the correction.
We expressed our concerns about China by going underweight in emerging market debt denominated in US dollars. This asset class has benefited from the search for yield among investors and has seen stronger inflows than emerging market equities. In an environment of fading liquidity, a lower appetite for this asset class leads us to conclude that emerging market debt is at risk of being the target of ‘hot money’ flows. This could be even more the case for corporate debt, which makes up about 20% of our investment universe.
As said, valuation-wise, emerging equities (particularly Asian) offer value in an otherwise expensive range of asset classes, while emerging market hard currency debt is neutral. It offers no yield pickup over US credit with comparable ratings and there is a risk that yields will rise in the US once the Fed starts tightening. Local currency debt has been bolstered by recent currency depreciations as the foreign exchange element has added to its appeal. Finally, local currency debt has lagged emerging equities by more than hard currency debt, while historically, the two asset classes have been closely linked.
Within Europe, we kept an overweight in high-yield corporate bonds for fundamental and carry reasons. We are overweight small caps versus large caps in Europe, which is related to our positive view on where Europe is in the economic cycle relative to emerging economies. Thus, we are exposed to European assets, but the exposure is somewhat hedged by our short euro position versus the US dollar.
In commodities, we don’t yet foresee a turning point in prices, and prices have fallen to very low levels. This level of valuations limits the further downside potential for commodities so we have closed the underweight in commodities.
In our flexible multi-asset positions, we implemented a convergence trade by going long US Dollar high yield debt versus credit default swaps, because the spread differential and spread ratio are attractive.
We have a long position in the Japanese yen versus the euro and the South Korean won to hedge China-related risk. The yen is traditionally a safe haven currency in periods of trouble. We don’t see any signs that the Bank of Japan will try to weaken the yen further through an increase in its quantitative easing. Given high exposure to China and domestic weakness, the Bank of Korea may cut even rates further at some point.
We are overweight the US consumer discretionary and information technology sectors, which should benefit from rising consumer spending.
We are positive on the outlook for Japanese credit and long 5-year forward US inflation swaps.
We are long the cheap Mexican peso versus the strong British pound and long the US dollar versus the overvalued Swiss franc.
We are long the yen versus a 50/50 split of the US dollar and the New Zealand dollar. Our valuation models indicate that the yen is cheap versus both currencies and, faced with weak economic data, the Reserve Bank of New Zealand recently had to abort its hiking cycle and started to cut rates in July. As in Australia, the central bank would like to see a weaker currency.
Just as in our core allocation, we are short the euro versus the US dollar.