Investment Insight: Preparing portfolios for a bubble burst

Darius-McDermott-700x450.jpgThere is no reason not to take part in the final stages of a bull market but expectations must be realistic

Speculation about how long the US equity rally can continue is almost a daily activity now. And is it any wonder? Where the US goes, the world follows.

Since the US equity market bottomed during the financial crisis in March 2009, the S&P 500 index has been lucrative for sterling investors, outperforming the second-best regional equity market index – the MSCI AC Asia Pacific ex Japan – by a whopping 100 percentage points, with gains of 371.8 per cent.

Seemingly never running out of steam, the US stockmarket enjoyed no fewer than 64 record highs in 2017. So, again, we ask: can this run of good fortune continue?

Arguably one of the largest tailwinds the US could benefit from is corporate tax cuts, the impact of which is already being felt – and not just in the US. Indeed, the Senate’s passing of the bill on the matter just before Christmas sent global stockmarkets higher.

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Core retail sales growth in the US is the strongest it has been since 2005. With corporate tax being slashed from 35 per cent to 21 per cent, companies such as Walmart that could save billions of dollars are feeling more confident and generous. Among other measures, it has raised its minimum wage to $11 per hour. This is particularly poignant, given research suggests lower-earners are more likely to spend any windfall than save it.

Manufacturing and construction data coming from the country also looks strong, not to mention that unemployment remains under 5 per cent. Many investors therefore believe the US Federal Reserve will continue hiking interest rates, which could bode well for US financials and value-driven stocks.

Bond markets

Another key factor – and one that has elongated the bull market – is quantitative easing. We have had so much central bank interference in developed bond markets, they are beginning to make China look stand-offish. And it is probably the bond markets that will set the tone as to how this year pans out. As central banks start to wind in QE, their reaction will be key – not just for their own fortunes but for those of the equity markets too.

The first two weeks have already seen a wobble. The Bank of Japan made one of its unexpected moves – reducing its bond-buying programme, while actually remaining a net-buyer to keep inflation in positive territory.

Have markets reached irrational exuberance?

The European Central Bank minutes were also more hawkish than expected. And rumour has it China is thinking about putting an end to its US treasury buying. According to Rathbones, they own about 20 per cent of all outstanding government debt. But while it is perhaps not an unreasonable decision, it is not a welcome one when the US needs the cash to pay for the tax cuts.

The result of all this was a rise in yields but, this time a least, it did not trouble the equity markets too much. The S&P 500 had its first single-day decline of the year but it was short-lived, with the market rebounding the next day.

Fund picks

So while we wait for the bubble to burst, how to position a portfolio?

There is no reason not to take part in the final stages of a bull market but expectations should be realistic, not exuberant and, if there is a sharp downturn in the market, investors need enough diversification to cushion them from at least some of the falls.

For those looking for exposure to US equities, Brown Advisory US Flexible Equity may present itself as a good option. Manager Hutch Vernon is completely unconstrained when it comes to investing style and tends to seek out undervalued mid- and large-caps, which are in the throes of improving their underlying fundamentals.

US small-caps could also be of interest, as there is a much wider investable universe and companies tend to be more under-researched. Hermes US SMID Equity invests in small- and mid-caps, which means it is vastly different to the S&P 500 index.

Away from the US, I think European, Japanese and Asian equities in particular could reward investors more handsomely over the long term. I like Threadneedle European Select or T. Rowe Price European Smaller Companies for the more adventurous. In Japan, I like Baillie Gifford Japanese and in Asia, GSAM India Equity Portfolio is worth a look.

As I have said, bonds are also expensive, so I prefer high yield funds where the income will at least shield you from some of the possible price falls ahead. I like Aviva Investors High Yield Bond (4.8 per cent yield) and Schroder High Yield Opportunities (6.2 per cent yield).

For added diversification, I actually prefer targeted absolute return funds like Henderson UK Absolute Return and Premier Defensive Growth.

And, just in case central bankers get it horribly wrong, or Trump finally throws markets with an inappropriate tweet, a small amount in a gold fund like BlackRock Gold & General, could act as a decent hedge.

Darius McDermott is managing director at FundCalibre

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