In exchange, we reduce real estate securities and various types of corporate bonds. We remain overweight the US dollar and gold, and for the time being remove the British pound from our portfolios completely.
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Economy: baseline scenario of moderate global growth maintained
Our baseline scenario remains unchanged: Europe’s economy remains mired in recession, while in the US there are signs of a pick-up of activity in areas ranging from housing construction to manufacturing. However, even the small steps of fiscal austerity in the US – or the residue of the once much-feared "fiscal cliff" – limit the pace of quickening growth. In Japan, the new leadership’s reflation policies have the potential to jolt the economy out of deflation, but they could also hurt growth in some of its export-sensitive regional competitors, such as South Korea. Emerging markets continue to offer a mixed picture: Mexico benefits from the reindustrialization of North America, but India’s growth path continues to deteriorate, while Brazil and South Africa face lackluster demand for their commodities. In China, policy planners now appear to be supportive of the general economy, but maintain a tightening bias when it comes to controlling the heated housing market. The bottom line results in modest global growth.
In our risk scenario, we see a low probability of a relapse into a global recession. The wild card here is Europe. Uncertainty arising from Italy’s inability to form a government and the recent events surrounding Cyprus add to Southern Europe’s pre-existing woes. The fact that European politicians were prepared to consider imposing losses on insured bank depositors has set a potential precedent for other troubled countries encountering similar difficulties in the future. This predictably raised questions about the sanctity of bank deposits in the eurozone as a whole. We will of course continue to look out for any signs of financial contagion to other markets, such as Italy or Spain. For now, however, we note that such signs have been largely absent from financial markets during the most recent excitement surrounding the events in Cyprus.
Equities: increasing exposure to a significant overweight:
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By GlobalDataWe have decided to increase the equity allocation to an overweight position, after having gradually built up positions in this asset class in several steps in recent months. Investors have become near immune to the lingering debt problems and the occasional bad news and/or political fiasco on both sides of the Atlantic, as the Cyprus example shows. Central banks are keeping the spigots of money wide-open, and have put in place backstops to counter any imminent credit crunches. The near-zero policy rates and negative real bond yields in virtually all so-called safe haven markets continue to push savers and investors to seek higher returns elsewhere – i.e. in dividend-paying equities. Stock market valuations remain inexpensive to fair overall, and sentiment indicators are positive, but not stretched. Strong recent money flows and some technical indicators suggest that markets could be ripe for a breather within the context of an unbroken uptrend.
Specifically, we are buying into all regions except for the emerging markets. We made the biggest purchases in Japan, followed by the US, Asia-Pacific ex Japan, and to a small degree in Europe. In Japan, stocks have had a tremendous run already, but much more could be in store if the country’s new administration implements anti-deflationary policies. We add that the increase in Japanese equities marks our third move concerning Japan (after removing the yen in early December and raising Japanese equities to neutral in January). In the emerging markets, higher economic growth has not generally translated into superior market performance or corporate profitability, with the emerging equity indices generally lagging the developed benchmarks in recent quarters – in some cases even longer. We have thus refrained from an increase of the emerging market allocation at this stage.
Fixed Income: reductions in corporate bonds:
Evidence of a "great rotation" out of government bonds and into equities is still scarce at this time. Institutional demand at debt auctions is still high. Fund flows have declined, but remain positive. It is more likely that excess cash is put to work in equity markets. It is also conceivable that investors are moving up the risk ladder by shifting from corporate bonds into stocks – a move we would endorse for the coming quarter. We retain our slightly underweight position in both nominal and inflation-linked government debt, and reduce positions in Investment Grade and High Yield debt to underweight. We also reduced Convertible Bonds. Corporate debt spreads have fallen back to levels at the onset of the crisis, which lessens the appeal of holding corporate debt. The rising number of rating cuts, corporate re-leveraging, and a trend towards shareholder-friendly policies (dividend hikes, share-buybacks, etc.) also represent developments that can reduce the allure of corporate debt relative to equity. Now, the moment seems opportune to lock in some profits. At the same time, we reiterate our view to hold a considerable portion of the remaining quota in high quality securities, with a preference for a rather short average maturity of about three years. We keep emerging market sovereign debt at a moderate underweight relative to the raised neutral strategic position, and tilt our preference a tad more towards hard currency bonds, as US dollar strength may prevail for some time.
Alternative Investments: Private Equity remains overweight but REITs cut to neutral:
Discounts on Real Estate Investment Trusts (REITs) and Listed Private Equity (LPE) have narrowed further, in some cases reaching rather unattractive valuation levels. After years of outperforming the broader market, real estate securities have also lost some technical upward momentum recently. We revert to a neutral position in the real estate segment, but keep the small overweight in LPE as a beta play – i.e. the asset class’ potential to outperform public equities during a bull market.
The commodity complex (excluding precious metals) remains lightly underweight. Somewhat better growth dynamics in the US, a stable but lower growth path in China (and the headwinds in its property market) are unable to generate upward momentum in generally well-supplied commodity markets. On a more granular level, we have a marginally better assessment on energy (overweight) and base metals (underweight) than last quarter. The fundamental narrative for gold remains intact in our view, although gold’s price trend is somewhat dented from a technical perspective. The fundamental drivers of the gold bull market (zero rate policies, currency debasement, safety of real assets, etc.) have not yet faded away in our view. A policy paradigm change at the Bank of Japan, the European Central Bank’s easing bias or the recent episode in Cyprus offer examples that should bode well for gold and other precious metals.
Currencies: overweight in US dollar maintained, exposure to British pound eliminated:
Relative economic performance and differences in the policy biases of central banks sustain our tactical conviction in favor of the US dollar versus the euro (and other currencies). We also note that we continue to prefer to hold Norwegian krona as a substitute for the euro in non-euro-based portfolios. We are also completely removing the British Pound from our portfolios from a tactical perspective (i.e. underweight Sterling). In previous quarters, we had fortunately resisted the appeal of the fundamentally undervalued British currency, as market signals were indicating the possibility of an accelerating downtrend. A temporary bounce from oversold levels is under way now, but most observers expect the new Bank of England leadership to ease its already ultra-loose monetary policy further in the near future, to prop-up the stagnant UK economy. Against this background, we prefer not to hold Sterling. We also note that we continue to fully hedge exposure to the Japanese yen, as a matter of principle, and hold no yen in our currency allocation.
