A recent asset allocation update noted that overweight positions in equities ought to be reduced, given the deteriorating emerging market/China background and the limited upside available on equities. For the year as a whole, however, the preference for equities is retained. An outlook of accelerating global growth and ongoing highly accommodative monetary policy over the next year or so should be positive for higher risk assets and negative for lower risk assets. Equities cannot rely too much on further revaluation, however, and improving earnings growth is a prerequisite for the 10% or so gains foreseen.
In summary, we recommend a modest overweight position in equities, an underweight in bonds and with credit – only just – preferred to government bonds and cash as it has substantial illiquidity risk. Commodities continue to face challenges in the “new world” and most forecasters expect long term prices to revert to lower levels. We are heavily overweight for UK commercial property, as it offers the prospect of equity-like returns but at much lower levels of risk.
A summary of the individual asset class views is shown below:
Equities
Despite growth slowing in the emerging world, an acceleration in activity in the developed countries is expected to generate a modest rebound in the global economy. Policy actions by DM governments and central banks should ensure recovery becomes entrenched and the consensus forecast is for DM GDP growth to be nearly double the 1.1% likely recorded in 2013. EM presents many more risks but is unlikely to cause the global recovery to stall. Central bank actions have helped lower perceived systemic risk and investors are beginning to rebuild equity weightings and a modest overweight position is retained on a medium term view. Currently, Europe and Japan are moderately overweighted and the US and EM modestly underweighted, although the US will likely outperform near term and an opportunity to add to EM is probable in the next few months. A small bias to cyclicality is recommended as the global economy accelerates and corporate spending gathers momentum. Value is increasingly difficult to find, however, especially in mid-caps and, while mega-caps look increasingly attractive value traps need to be avoided although, at this stage of the cycle, M&A and/or restructuring could be a catalyst for outperformance. Higher yield with growing income is also a favoured theme. Near term, turbulence is spreading from EM to DM but appears unlikely to deteriorate into more than a warranted near term correction. This could well provide investors with an opportunity to rebuild equity weightings.
Bonds
With economic recovery hopefully underway and the US Fed initiating a gradual decline in bond purchases, the era of extraordinarily low yields is over. In the US, 10-year yields have more than doubled from their lows, but most forecasters still expect them to move higher during 2014. US yields should hold above the 2.50% level and, with the long term trend being upward, returns could well be negative in real terms over the year. For some considerable time corporate bonds have provided, and still offer better inherent value, given the economic outlook and expected low default rates, especially at the riskier end of investment grade and in high yield. This is receding, however, and investors must be aware these are illiquid markets prone to high volatility when risks are rising. EM debt remains highly volatile and investors should note that more positive trends in DM do little to resolve the short/medium term imbalances in a number of important EM countries.
UK Commercial Property
Values continue to rise. The outlook for the year has become far clearer with improving financing availability and growing interest in both prime but particularly secondary properties, even outside of the M25. Increases in capital values have overtaken income in monthly returns and with a near 6% starting yield and a still very wide yield gap relative to bonds and cash, property remains attractive to income-starved institutions and those seeking an equity-like but lowish risk total return. While it is difficult to find suitable vehicles investing directly into commercial property that can replicate IPD index performance, fund returns are improving and the AREF/IPD Balanced Pooled Fund index generated a 4.3% gain in Q4.
Commodities
A global economic background of slower EM growth, combined with the reform and rebalancing of a Chinese economy generating a significantly lower trend growth rate, presents a more difficult medium term backdrop for many commodity producers. This represents a departure from the structural bull market witnessed during the last decade and will lower potential returns until capacity tightens again. This is not a new story and commodity indices have been underperforming for over two years. A large part of the prior upturn in commodities was driven by speculative activity but interest in this newish “asset class” continues to wane. This has become increasingly evident in gold and, with EM likely to slow further and supply increasing, oil and metal prices will find it difficult to sustain any upward momentum. Consensus forecasts are for a flat to lower long-term price structure.
Currencies
As ever, there is little consensus on the outlook for currencies, the one exception being the medium term near universal yen short. Logically, the dollar would seem to be the most obvious choice for some outperformance in the early part of the year given economic trends and EM turmoil, while the yen will also act as a short term safe haven. Sterling, quite rightly, has near term momentum but this may prove difficult to sustain on a medium term view with a sizeable and growing current account deficit. The EM fx correction may well extend, but sentiment should improve as the year progresses.
