Try to keep calm amid the unusual calmness

Experts feel equity prices have run ahead of fundamentals

The idea of taking your money out of equities and putting it into more expensive bonds is painful because of the low yields that bonds offer.” Craig Mackenzie | Aberdeen Standard Investments

The unusual calm still prevails in the market, despite the headwinds, but fund managers are not calm. The record breaking rally in US equities has been in place since 2009, and the S&P 500 index has gained 280 per cent since then. The US indices have continued to extend their weekly gaining streak, and are still up 14-15 per cent so far in the year.

But Craig Mackenzie, a Senior Investment Strategist with Aberdeen Standard Investments is already strategising against any tail risk events like reversal of the $2 trillion (Dh7.34 trillion) liquidity from the Quantitative Easing programme of central banks or popularly called easy money policy, or a $22 trillion debt problem — equal to the size of European banking sector, in China, which contributes to a third of global growth.

“There are two things that I’m concerned about. One is quantitative easing. The Fed has said that they will reverse that. That means they will take money out of the market and therefore draining liquidity by reducing their balance sheet and selling bonds back to the market.

“The ECB is saying they will reduce QE. We will see the QE flows going down from $2 trillion a year to zero by the end of next year,” Mackenzie said.

China conundrum

“The other thing is China, whose growth has been driven by private sector credit growth. When you grow credit very fast like that, banks end up financing projects that are not economically viable, and may turn into bad debts,” he said.

The painful reality for investors is the question of where else they will put money amid high valuations.

“Prices have gone ahead of themselves and US equities are now 20 per cent more than the fair value. Valuation matrix now suggests that once or twice in history, US equities were more expensive,” Mackenzie said.

“The idea of taking your money out of equities and putting it into more expensive bonds is painful because of the low yields that bonds offer.

“The challenge facing big investors is if valuations are expensive, where else do we put your money,” Mackenzie added.

US treasuries are expected to offer 1-1.5 per cent yields now compared to 5 per cent in 2006, while European bonds may offer 0.50 per cent yields.

That’s the reason why he has made his portfolio insulated from any risks, and still robust for the long-term by focusing on and diversifying and increasing exposure to emerging markets or alternative investments, which are less sensitive to any changes in QE.

Slimmer portfolio

His portfolio is looking a lot slimmer on developed markets, and diversified into emerging market local currency bonds, asset backed securities and secured loans.

“I’ve made huge gains in equity portfolio in the last five years, so I’ve taken some profits off the table, and have invested in assets that are less sensitive to QE like emerging market debt,” Mackenzie said

A few years ago, he invested 40 per cent of the portfolio in equities, 40 per cent in government bonds and investment grade bonds, 20 per cent property, but now he prefers investing only 25 per cent in equities, 25 per cent emerging markets local currency bonds, which yields 6 per cent returns, and 15 per cent in alternative assets, 10 per cent in loans.

“Its very tempting to be greedy in good times. We had a very good returns in recent years. Now we will take some equity risk off the table, pocket some profits, and diversify the risks, so we are less exposed when the bad times come,” Mackenzie told Gulf News during his field visit to Dubai.

1990s Dotcom bubble

The big question, according to Mackenzie, is what might end the positive sentiment in markets.

“Once valuations get high as they are today they can’t stay expensive. Many investors got quite badly hurt during the dotcom boom in the 1990s. They saw equity prices getting expensive and they took the money out of the equity market, and the equity market went up by another 30 per cent. We could be in a position again, where equities continue to deliver 7-8 per cent per annum for 2-3 years,” he said.

“If something bad happens then people may suddenly lose confidence, and we may see a correction of 20 per cent. The higher the prices get, the more there is the risk of a substantial correction,” Mackenzie added.