As asset allocators, we look at where there are attractive opportunities. Here our Multi-Asset Solutions team share their outlook for their broad investment universe and where to find the best risk-adjusted returns.
In the first half of 2018, we have seen volatility return to markets, a breach of the much anticipated 3% handle for 10-year US Treasuries, and an agreed summit between North and South Korea. As we continue to tread later into this cycle, investors seeking a consistent long-term real return must balance the need for returns with capital preservation.
Developed market equity valuations remain high
Equity valuations in most major developed market countries remain high, with the US appearing the most expensive, even on a forward looking basis. On a relative basis, Australian equities have performed strongly, lifting the forward P/E ratio from late last year. Europe looks more attractive from a valuation perspective. Europe has strung together 19 consecutive quarters of growth and prospects for earnings growth remain healthy, so we still see selective value in European equities, despite political instability.
Emerging markets equities look more attractive from a valuation perspective
While volatility has increased in emerging markets, current levels do offer a chance to increase exposures. Historically, emerging markets have been exposed to a weaker US dollar, but over time emerging market economies have been able to borrow in their local currencies and move away from hard currency borrowing, which we believes lowers their vulnerability, relative to previous crises in those regions.
Government bond yields should trend higher
Developed market government bonds are breaking out of the multi decade bull-run, and we have started to see the much anticipated rise in both short and long term yields, as evidenced by the US 10-year bond breaking through the 3% level. The path to higher yields is expected to continue to trend higher after a period of consolidation following the recent volatility. Some inflation-linked bonds offer value, and we continue to hold these in Australia, with the risk of higher inflation than we have experienced in the last couple of years. For global investors looking for a real return (i.e. a return over inflation), fixed income provides little direct help.
Emerging market debt offers relatively attractive risk-reward
Emerging market credit continues to offer relatively good risk-reward, with global trade increasing and commodity prices underpinning expansion, and the higher yields offering a reasonable carry return to hold the higher volatility expected from these assets. We continue to allocate our duration exposure to emerging market bonds, both hard and local currency. There are few places where high real yield is available without credit risks (countries like Brazil, Mexico, and Russia). Furthermore, countries that have to borrow because they save less than they invest have to pay a higher interest rate and are often more economically vulnerable to shocks. Our global investment universe allows us to invest in countries where the return looks attractive on a relative basis.
Credit market have pockets of value - prefer investment grade credit, especially following recent spread widening
Fundamental drivers of fixed income markets in 2018 suggest that yields should continue to rise, particularly if inflation increases. Credit, in particular investment grade, has not had a positive start to 2018 within this backdrop. However, we still see value in high quality global corporate issuers, particularly following recent spread widening. We do not hold any high yield after selling down this exposure in late 2017.
Where are we invested?
Within our investment process we have two building blocks. The first, which we call Neutral Asset Allocation (NAA), sets longer-term asset allocations, which are formally reviewed approximately every 6 months. As a consequence of our outlook for the global economy and the current valuation levels, we have sold all of our remaining exposure to global developed bonds and reallocated this to emerging markets bonds (hard). We have taken the more palatable equity valuations as an opportunity to reduce our cash allocations and reallocate it to equity, including marginally increasing the proportion of global equities towards emerging markets. Finally, we have added to the allocation to commodities.
|Asset class||Asset allocation as at 31 May 2018|
|Australian Government bonds||20%|
|Global bonds (hedged)||0% (decrease)|
|Credit – investment grade||15%|
|Credit – high yield||0%|
|Emerging market bonds – local||3%|
|Emerging market bonds – hard||11% (increase)|
|Australian equities||15% (increase)|
|World equities||18% (increase)|
|Emerging markets equities||6% (increase)|
But markets are not static – and neither are we. We continually review our investment signals and qualitative overlay to take advantage of market dislocations during the second part of our investment process, Dynamic Asset Allocation (DAA). This allows us to exploit shorter-term opportunities in markets to help us achieve our clients’ return targets as we move into a lower return environment.
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