Stay ahead of the curve with our experts’ breakdown of this month’s market shifts and the insights shaping our portfolio positioning.
Fast reading:
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The change of administration in the US and what policy changes will occur as a result was, and still is, the major issue facing equity markets. We have a high exposure to the US equity market.
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US bond yields have continued their upward trend since our last Asset Allocation Committee meeting on 14 October, while European bonds have remained relatively stable this month.
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Currency risk is an important element of the risks facing an investor. Our portfolios are managed with a policy of not taking currency risk in our fixed income allocations, but we do take significant currency risk within our global equity allocations.
Equity markets brace for policy changes
Since the last edition of Portfolio Perspectives, the world equity market continued to ‘grind’ higher adding another 1% in local currency terms over the period. A weaker euro converted that into a rise of 3%. The US election was the dominant issue as the Republicans gained a ‘clean sweep’ and generated major differences in regional performances. The US was up 2.5% while Asia Pacific dropped 4% and the euro area declined 3.2%.
The change of administration in the US and what policy changes will occur as a result was, and still is, the major issue facing equity markets. The themes that are being focused on are: taxation; trade; regulation and immigration. We know these will be changing going forward but to what extent is still uncertain. There are some general conclusions we can come to:
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There will be higher tariffs in the US – this is negative for growth overall but leaves the US stronger relative to the rest of the world.
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Fiscal policy is set to remain loose which is a positive for growth in the US.
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Deregulation could raise the economic growth rate, but it will improve the earnings outlook for US companies.
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Reducing the flow of immigrants will hinder growth and crimp company margins.
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Cuts to corporate taxation will boost earnings but may not impact on economic growth to any great extent.
The new programme is US centric and thus likely to produce a more resilient US economy relative to the rest of the world with the emerging economies most at risk. To some extent we had prepared for this outcome. We have a high exposure to the US equity market and low exposure to the Asian region. We increased cyclical exposure due to a more robust US economy and kept towards structural growth. Until we get a clearer picture of what policy will look like, we do expect volatility but equity markets remain quite resilient.
Bernard Swords, Chief Investment Officer
European bonds: calm amidst uncertainty
While US bond yields have continued their upward trend since our last Asset Allocation Committee meeting on 14 October, European bonds have remained relatively stable this month, with yields only marginally higher.
US bonds had been priced for “perfection” coming into the 50-basis point interest rate cut in mid-September, having reacted more aggressively than in previous cycles to the early rise in unemployment over the summer. They have since been caught off guard by a partial reversal of this rise, coinciding with a slowdown in the rate of disinflation. Not even a further 25 basis point interest rate cut on 7 November could halt the ensuing repricing of rate cut expectations, which persisted until the confirmation of Donald Trump’s election as the next US president.
Short term uncertainties surrounding Trump’s prospective policies had been factored into bond prices by the time the election results were known, and prices have since traded in a range. However, significant questions remain to which comprehensive answers are unlikely in the near term. Speculation is likely to continue regarding the impact of new tariffs, corporate tax cuts, deregulation, and immigration constraints, suggesting further volatility in US bonds in coming months.
In contrast, European bonds have provided a relative oasis of calm and steady returns since our last update. Economic growth and employment data in core EU countries remains weak, with few signs of resurgence. The recent ECB interest rate cut is unlikely to be the last.
We see better value in shorter-maturity bonds that benefit from these rate cuts while remaining relatively insulated from the fiscal and political stresses affecting Germany and beyond. Consequently, our portfolios remain short of their benchmark durations, and we continue to overweight corporate credits, anticipating that the available spreads adequately reward these investments.
David Thompson, Head of Fixed Income Strategy
Portfolio construction: what to do about currency risk?
Currency risk is an important element of the many risks facing global investors and is a significant challenge for portfolio construction. Our portfolios are managed with a policy of not taking currency risk in our fixed income allocations, but we do take significant currency risk within our global equity allocations.
The rationale for this policy is that fixed income instruments have a relatively predictable principal value and primarily play a relatively steady, income-generation role within a portfolio. So, adding currency volatility would typically bring disproportional risk to the benefits of that income, at least in the short term. In practice, we invest largely in home-currency fixed income instruments, where currency risk does not arise.
By contrast, equity markets are relatively volatile, have higher expected capital return, and don’t have any relevant principal value. As such, the proportional contribution of currency exposure to the equity risk of a portfolio is less. There is also the complexity that currency movements can directly impact earnings and equity prices. In practice, we typically accept currency risk as part of the regional equity allocation decision and do not seek to hedge it.
Most of our foreign currency risk is in US dollars. There are three reasons why we remain comfortable with this level of currency risk and choose not to hedge. First, although the US dollar is relatively expensive versus the euro on a purchasing power parity basis, its valuation is not near historical extremes which might trigger realignment on valuation grounds alone. Second, US economic growth is relatively strong, having surprised to the upside for two years running, suggesting little cyclical catalyst for depreciation. Lastly, US interest rates are relatively high and so hedging US dollar exposure is relatively expensive.
To be sure, there is risk that the incoming US Administration seeks a weaker dollar for competitive reasons. But as cyclical and valuation forces are not compelling, currency risk should still prove to be limited in the medium term. Indeed, if US tariffs are imposed on a wide array of foreign imports, shifting the terms of trade, the dollar may be more likely to strengthen than weaken.
