Battered sterling is the price of Brexit
- Caution abounds, bonds very unattractive
- Political risk rising in Europe and US
- Positive on emerging markets and Japan
Both shares and the property sector have recovered much of their lost ground in the initial reaction to Britain's vote to leave the European Union (EU).
But the pound has remained well below its pre-Brexit levels, hitting an all-time low in mid-October in response to concerns over the government's Brexit plans.
BONDS LOOK UNATTRACTIVE
Is it realistic to expect sterling to make something of a comeback? This is a key question for investors diversifying on the world market, because the purchase or sale of any asset outside the UK - bonds, shares or property - implies a switch in currencies as well.
Alan Higgins is one of our panel of asset allocators who thinks there is a fair chance that the pound may soon make at least a partial comeback. For this reason he is urging investors to avoid global government bond funds at the moment. He gives the global bonds sector on our scorecard an unusually low rating of 1.
Higgins, UK chief investment officer at Coutts Bank, used to be a bond market specialist. 'Being in bonds looks to me to be a very unattractive proposition at the moment. Typically, you will be selling sterling to buy a foreign currency - dollars, euros or yen - in order to purchase a global bond fund.'
He argues the currency risk exposure is not worth it for a measly 1.5 per cent return on dollar bonds or a zero return in euro or yen bonds. 'I might look very foolish in a few months' time,' he admits, 'but at the moment it is a big risk that is not worth taking.'
For some time our panellists have tended to give underweight positions (scores below 5) for both UK bonds and global bonds.
None has previously gone to Higgins's extreme position, but Chris Wyllie of Connor Broadley comes close. Wyllie lowers his global bond score from 4 to 2, describing them as 'an extremely unattractive proposition'.
Rob Burdett of F&C Investments offers more supportive words: 'The overall risk/reward ratio for government bonds is simply bonkers. But the forces of supply and demand sometimes override the logic.'
As central banks continue their quantitative easing programmes, they are responsible for picking up their governments' debts on a massive scale through bond purchases.
'I cannot see that changing in the short term,' Burdett says. 'If anything there is a risk of the central bankers supporting bond markets even more strongly.' He keeps his global bond score at 5.
Richard Dunbar at Aberdeen Asset Management is still in no mood to 'bet the farm' on any one bright idea. So all his scores for different sectors hover between 4 and 6.
Typically cautious is his attitude to bonds. He admits: 'If I was inclined to change the scores here I would lower them'; but he keeps them at 4.
Keith Wade of Schroders also keeps his UK bond and global bond scores at 4. 'We think the Bank of England may ease monetary policy even further, and that makes us cautious about the outlook for sterling,' he says.
Longer term, he sees the new government team under Theresa May having a hard time negotiating Brexit. 'We are in a phoney war period,' he says.
'They may not make a lot of progress for a while, and only when the deadline approaches after two years will things begin to happen. Against that background, I could see the pound weakening.'
Even Wyllie sounds bearish about sterling in the longer term. He is doubtful about the likelihood of a sterling rally, especially given the currency's recent falls.
'We need a cheap currency because that is the only way we are going to get anyone to invest in the economy in the next couple of years.'
Global financial markets meanwhile face a continuation of the low-inflation/low-growth scenario. 'Now there is a risk of recession in the US after next year,' Wade says.
'It is still such a driver of the world economy, yet it is likely to grow only 1.5 per cent this year and maybe just 1.8 per cent next year.'
Meanwhile, he points to other unpromising areas of the world: 'China is continuing to decelerate and Europe is just muddling along, so all in all this does not make for a very strong economic environment.'
Burdett observes that the World Bank and the International Monetary Fund are gradually reducing world growth forecasts for this year.
'Next year could be even more challenging, though that is not yet in official forecasts,' he warns. 'Three months ago we were slightly overweight in equities. Today we are neutral.'
Wyllie sums up the global scene as 'continuing sub-trend growth but not yet recession.' Before that risk of recession happens, governments and central banks may well decide on further measures to beef up global growth.
'There is much talk of a move by governments from monetary policy towards fiscal policy,' says Dunbar.
Wyllie thinks the pressure of the popular mood among the electorate is 'forcing politicians everywhere to abandon austerity'.
He sees the UK and Japanese governments already moving in that direction: 'The Bank of Japan has effectively written the government a blank cheque by promising to cap bond yields. In effect the Japanese government can borrow as much as it likes because the central bank will keep on printing money.'
It seems central banks generally would like to see a bit more inflation and a bit more growth. With more inflation, there might be less need for negative nominal interest rates.
Wyllie also maintains that in Europe the Germans are 'in retreat on fiscal orthodoxy'. He believes the interests of European unity will mean a relaxation of the purse strings amounting to more government spending, perhaps accompanied by tax cuts.
This possibility is keeping the equity market bears at bay to some extent, in hopes that the bull run still has some way further to go.
One bullish straw in the wind for the panel members is indications that the long bear market in commodities - industrial metals in particular - may be coming to an end.
Notably, Wade has raised his score here from 5 to 7. A possible coordinated response by Opec to the global oil glut is another encouraging factor.
For two key sectors, the US and the UK, scores are the same as they were in the last review. That is apart from a nudge down from 5 to 4 for the UK from Dunbar, who is 'sourcing cash from there for better ideas elsewhere'. Scores of 5 predominate in both these sectors, reflecting the general mood of caution.
That too applies to the property sector, with only Higgins now staying overweight. Wyllie raised his property sector score last time from 5 to 7, against a general post-Brexit background of pandemonium. The market did duly recover much of its poise, so he is now lowering it back to 5.
Burdett highlights some intriguing defensive niche investments in real estate, including a company specialising in student accommodation and another in caravan parks ('in recessions the student population tends to rise and more people holiday at home', he says).
The panel do not seem too worried about the possibility of Donald Trump becoming the next US president. 'The institutions on which the US is built have deep roots,' says Dunbar.
'They are deeper roots than one man can dislodge in four years.' Wyllie agrees: 'If it is Trump, how many of his outlandish policies will see the light of day? History suggests most of them will be quietly dropped.'
JAPAN IN FAVOUR AS EM PROSPECTS IMPROVE
All the positive action seems to be in Japan and emerging markets, where optimism is rising. None of the panel members is now underweight in Japan, after three of them have raised their scores.
Japan's currency, the yen, is up by around 41 per cent against the pound this year (to 13 October) and the performance of the Investment Association's Japan sector in sterling terms is up 23 per cent since 24 June - entirely reflecting the currency rather than underlying share performance.
Dunbar, who has raised his score from 5 to 6, describes Japan as having 'reasonable value compared with other equity markets'.
Wade believes the Bank of Japan will cut interest rates and increase its inflation target to get growth growing. 'The yen might now weaken,' he predicts. He raises his score from 4 to 5.
If Japan is coming back into favour, European equities are losing out. Three of the five panel members are now underweight in the sector.
Burdett, who has lowered his score from 4 to 3, says the region faces 'a litany of political issues' in the coming months - including elections in Germany and France. On top of this are continued rumblings of banking problems in Italy and Germany.
Dunbar is more sanguine. 'There is plenty to worry about in the banking sector. On top of this I suspect Brexit asks as many questions of European politicians as it does of the British government.
'Even so, many eurozone economies are doing better than many would have thought a year ago, and there are plenty of good companies to buy,' he asserts.
It has on the whole been quite a good year in emerging markets, with the MSCI Emerging Markets index up by a third since the start of this year.
Part of the gain again reflects the weakness of the pound since the EU referendum result, with the same index gaining 14 per cent since the end of June.
But it also reflects improving prospects of many emerging market countries. If there is any common denominator among countries ranging from Vietnam to Brazil and India to Turkey, it is the signs of the end of the long bear market in commodity prices.
'Of course different emerging markets have different drivers,' admits Chris Wyllie.
'The key signal to start them performing again after a long bear phase has been a recovery in the oil price from below $30 (£24) a barrel to nearer the $50 level. Now there has been a stabilisation of industrial metal prices as well.'
In particular, Brazil, Indonesia and Russia have all seen their markets recover strongly this year.
Emerging market equities is now the panellists' most favoured sector, with three scores of 7 and two of 6. Alan Higgins has lifted his score from 6 to 7.
'The sector has underperformed for many years, but the stabilisation of currencies has made it more attractive... and of course many of the equities in these markets are cheap.'
In August Rob Burdett raised his score here from 6 to 7. 'They have had a good run this year, but I think they can go further,' he says.
Keith Wade is now putting Schroders overweight in emerging markets, raising his score from 5 to 7.
'There are signs of recovery coming through, and compared to the US and Europe there is in our view less in the way of political risk. There is quite a bit of value in those areas we don't see elsewhere.'