Wild first quarter causes asset allocation panel to take cautious stance
- Central bank action and commodities ends market slide
- Being underweight or neutral on US equities was wrong call
- UK equities provide many reasons to sit on the fence
Our panel of asset allocators are licking their wounds after one of the most turbulent periods in markets in recent memory.
Equities plunged from the beginning of the year and by mid-February they were around 20 per cent down from their peaks of last spring. In April last year the FTSE 100 was peaking at around 7100; by mid February 2016 it had slumped to 5537.
People were talking freely of the US going into recession. There was a rumour of Germany's biggest bank needing a bail-out. Everyone wondered: were we heading back to a re-run of the 2008 crisis?
ON THE DEFENSIVE
Alan Higgins, chief investment officer at Coutts, points out that there are broadly two types of stock market correction: 'One is recession-led; the correction can be in the 40 to 50 per cent range.
'The other type is financial-led or sentiment-led, and then the falls are between 10 and 20 per cent. When you are in the middle of it, you have to make a judgement about what sort of correction it is.'
Indeed the US's leading share index, the S&P 500, was showing a small gain by the end of the first quarter.
'A combination of central bankers' actions, recovering oil and industrial metal prices and the fact that the world economy did not actually fall off a cliff helped the markets pick up,' explains Keith Wade, chief economist and strategist at Schroders.
'We have gone back, it seems, to the mediocre world of modest growth.'
But does anyone trust this rally? Our panellists are for the most part still a bit shell-shocked and on the defensive.
'The world has become an even more uncertain place in the past few months, and certainly financial markets have,' says Richard Dunbar, deputy head of global strategy at Aberdeen Asset Management.
However, Connor Broadley's chief investment officer Chris Wyllie says: 'We have been sellers into this rally, but being defensive does not mean we are bearish. There are upside risks as well as downside risks.'
Dunbar sums up the extraordinary mood swings we have seen so far this year: 'The lesson of the past few weeks must surely be not to bet the farm on any particular bright idea. Circumspection is the watchword.'
He cannot recall ever seeing such dramatic swings in market mood over such a short period. 'I have seen changes of view suddenly when things have actually happened, but I have never seen such sudden changes when nothing really has happened,' he says.
'At the end of December, the markets were pretty sanguine about the prospect of further US interest rate rises based on the need to apply the brakes gently.
'Just a few weeks later the mood was that there might have to be interest rate cuts instead of further rises. Now we are back to expecting a couple of rate rises later this year.'
At their gloomiest in mid-February, markets were predicting the US slipping into recession. In the end the US was the best equity market to be in during the volatile early weeks of 2016. Last quarter the panellists all went underweight or neutral on the US, bringing the average score down to 4.2.
WRONG CALL ON US
That proved a wrong call. By the end of March the S&P 500 was up 4.4 per cent in sterling terms, thanks largely to the strength of the US dollar, and was performing better than other major markets.
Now Wyllie, hitherto the most negative panellist on US equities, has changed his stance and raised his score from 3 to 5.
He admits: 'There are some valuation challenges in US markets, but there are some attractions, particularly as there are now signs that the central bank is trying to talk down the dollar.'
Keith Wade at Schroders has gone one better and raised his US equities score from 4 to 7. 'What we have done in the past three months is switched around an overweight position in Europe with an underweight position in the US.'
But he warns of potential snags: 'Profit growth is weak on the evidence of final quarter results in 2015, and that is not just confined to oil companies. But generally US companies have cash on the balance sheet to weather the storm.
'These days, investors are focusing on dividends and equities as bond replacements. The US is generally lower-risk and less volatile.'
Higgins retains his score of 5 in the US while drawing attention to the so-called dividend aristocrats - S&P 500 companies that have consistently increased dividends over the past two decades or more.
These, he says, are the quality long-term growth companies people are willing to pay up for in times of uncertainty.
Rob Burdett, co-head of multi-manager at F&C Investments, is now the only member of the panel with an underweight position in US equities. He is keeping his score at 4 'because there are now signs that the dollar can go down as well as up'.
It has been the strength of the dollar, particularly against the pound, that has given US markets a boost for UK investors so far this year.
One important change that has occurred in financial markets this year is the evidence that the central bankers are not quite able to orchestrate matters the way they would like.
The US Federal Reserve's Janet Yellen has found it necessary to become more and more dovish about interest rates to calm down markets.
Meanwhile both the Bank of Japan and the European Central Bank found they could not engineer further falls in the yen and the euro in response to yet more monetary stimulus through negative interest rates and additional quantitative easing.
Instead, both the yen and the euro have moved higher. In response some panel members downgraded their scores for both European and Japanese equities. Richard Dunbar has reduced both scores from 6 to 5. He had a 7 for Japan back in November.
'All we are left with in Europe is a Japanese concoction - negative interest rates and still little or no growth,' says Wyllie.
'It opens up the prospect of deflation, so I don't think central bankers have any choice but to chuck the kitchen sink at the markets to try to achieve meaningful growth.' He has lowered his scores from 5 to 4 for both Japan and Europe.
But Burdett is leaving his European score at 6 on the grounds that the underlying market valuations for companies are enough to support his continuing overweight position. However, he is lowering his score for Japan from 7 to 6.
'We are now focusing our investment strategy there on domestically focused companies rather than exporters,' he says.
'In Japan unemployment is at record lows, but the deflationary psychology is such that the local bank union has suggested to members they ask for a zero rise in wages!'
Meanwhile, Higgins refuses to back off from his bullish stance on both Europe and Japan and keeps his scores at 8 in both cases.
'We have to hold our hand up and admit that as of the middle of February we had definitely made the wrong call and we did not see the correction coming,' he says. 'But then we have to ask: what do we do now? To be consistent, we are going to stick with our equity scores.'
His belief is that 'the slowburn benefits of cheaper oil will eventually work through to consumers and to the industrial cost base'.
Our panellists seem to believe that the attractions of the property sector may have peaked. Even superbull Higgins has lowered his score from 9 to 8 and is 'trying to invest away from London'.
Dunbar has lowered his property score also, from 7 to 6, simply on the grounds that the sector has had 'a fabulous run' over the past four or five years.
Wade is somewhat concerned about the impact of the EU referendum on the London property market and is also trimming his property score from 7 to 6.
In contrast, there is increasing support from the panel for both emerging markets equities and commodities. 'We may well be over the worst in commodities,' says Burdett, whose score goes up from 5 to 6.
He is doing the same in emerging markets. 'Valuations are attractive there and there is already a big positioning away from emerging markets that could provide potential support [as investors return],' he says.
'Meanwhile the currencies of some of these countries, ranging from Argentina and Brazil to Russia, are stabilising while current account deficits are improving.'
Finally, there is increasing interest in corporate bonds for securing decent returns in a market less volatile than that for ordinary shares.
During recent market weakness Schroders has been buying high-yield corporate bonds, and Wade now lifts his score from 6 to 8. Higgins has raised his score also from 6 to 7, while Burdett has followed suit with a rise from 5 to 6.
UK EQUITIES: MANY REASONS TO SIT ON THE FENCE
The prospect of a referendum on Britain's exit from the European Union has led investors wondering how to play the UK equity market in the run-up to the 23 June vote.
If we vote to leave, will shares crash? In the months and weeks before the crunch date, will UK markets weaken? They are already underperforming other major markets. However, so far all the pressure has been on the currency, not on equities, and that may continue.
Higgins is keeping his UK equities score at 8; he is more or less convinced that the nation will vote to remain in the EU.
'Leaving the EU will introduce a big risk factor,' he says, 'although in the long run the UK economy could come to terms with it.
'But it is worth remembering that when Britain left the ERM (Exchange Rate Mechanism) in 1992, the pound fell but the market bounced back. Subsequently the FTSE 100 rallied by 50 per cent.'
The majority of our panellists are neutral on UK equities, but they recognise the protective power of exposure to the FTSE 100.
'The weakness of the pound against the dollar means that all the overseas earners in the FTSE 100 do benefit, and it could be quite good for the market,' says Schroders' Wade.
Indeed most of the panel seems to be working on the assumption that the vote will go convincingly in favour of staying in.
But it is also comforting to know that 60 to 70 per cent of the earnings of all FTSE 100 companies derive from abroad - so even if there is a shock Brexit result, our leading companies will be better placed to cope with the aftermath than many smaller firms.
The current crisis in the steel industry reminds us that in any case the UK economy has plenty of problems even without the EU question being considered.
There are fears of slower growth also, if for no other reason than the continuing policy of fiscal tightening by chancellor George Osborne.
So, at the moment, there seem to be plenty of reasons for our panel to remain mostly sitting on the fence.