Aberdeen Asset Management
Cautious optimism would best sum up our view at present. From a valuation perspective, particularly relative to government bonds, equities look reasonably attractive and coupled with the recent Federal Reserve and European Central Bank easing of monetary policy, this should provide support and appears to have significantly reduced the chances of a major correction. We do, however, remain cognisant of the potential for economic growth momentum to undermine this picture and any upward drive in equity markets may not be sustained into 2013.
Recent market weakness has to a large extent been driven by concerns over the simultaneous expiry of tax breaks with the introduction of tax increases and spending cuts at the end of 2012 in the US – the so-called ‘fiscal cliff’. However, the consensus is that disaster will be avoided and a last-minute deal reached. We subscribe to this view, but are also aware of the longer-term implications of such an outcome. Any hurried agreement may well lack detail and have potentially negative consequences for the US credit rating. A continued period of below-par US growth remains far more likely than a return to recession.
In the fixed income arena, the diversity of the market has never been clearer. This diversity results in certain segments of the market performing quite differently to others. For example, emerging market bonds are still generally treated as more risky when investor fear takes hold. Yet in the same environment, core developed market bonds (such as US, UK and German) should perform well in times of such stress.
Geographic and credit quality differences can present opportunities. At the country level, we favour the attractive characteristics of Asian and emerging markets. Their healthy public finances, favourable demographics and dynamic economies are all positives. Having reformed their economies following their own crises of the late 1990s and early 2000s, they entered the recent 2007/08 financial crisis in better health. This enabled them to weather the storm better than they might have previously.
As multi-asset investors, we have long been in favour of the strong and steady cashflow-generative nature of infrastructure and see it as an increasingly important sector. The investable universe will undoubtedly expand as developed markets are forced to face up to decaying infrastructure. Furthermore, as the emerging markets consolidate their status as the growth engines of the world and developed markets grapple to keep up, we are confident of the long-term potential of infrastructure across both.
Low correlations to the traditional asset classes also make it a useful diversification tool and many infrastructure assets have an element of inflation-linking built into their underlying contracts. In terms of risk, it tends to fall towards the lower end of the scale given the characteristics of the underlying investments. This, however, by no means implies that infrastructure is risk-free and those assets associated with a large degree of construction risk have borne this out over time.
It is fair to say we still remain constructive, but also mindful, of the risks both to this relatively benign outlook and market perceptions of those risks. It is unlikely that any change to generous liquidity provisions is imminent. Valuations remain supportive, though the earnings outlook is still a concern. A positive batch of economic data could provide a boost for risk markets, as could a resolution to the US budget debate. However, a variety of uncertainties remains, not just in the US but in Europe and elsewhere. This, and the consequent prospect of further volatility, reinforces our continuing cautious attitude.
Mike Turner is head of global strategy and asset allocation at Aberdeen Asset Management
Jupiter Asset Management
It is no secret why growth is slowing in the West. When consumers and companies are saving and not spending, demand gets asphyxiated as fiscal policy tightens. Growth slows further when powerful uncertainty grips companies and their investment plans are put on ice. Central banks have stepped into the breach but, no matter how much liquidity they supply, they seem unable to stimulate economic growth. This may be because the money remains stuck in the financial system since banks are as reluctant to lend as customers are to borrow.
The eurozone crisis is the major destabilising factor for growth prospects around the world. Many politicians realise the situation is not sustainable but feel monetary union is too difficult and expensive to break up. More buying of short-term government bonds by official institutions defers but does not solve the underlying problems of solvency and competitiveness for the peripheral economies.
It is important at times of extreme market distortions to avoid the tendency to start justifying current valuations as a ‘new normal’ and slip into the dangerous thinking of ‘this time it’s different’. We acknowledge the challenges of ‘fighting the Fed’, but nevertheless we believe sovereign bonds are poised to experience significant falls when this massive monetary experiment eventually unravels.
As part of our risk-driven approach we use a wide range of strategies in the Jupiter Strategic Reserve fund. We present these within a tripartite approach related to equity, fixed income and currency.
In fixed income, our largest exposure is short positions in supposedly ‘risk free’ sovereign bonds which are in our view extremely overvalued. In particular, we think French bond yields do not offer a sufficient risk premium should the eurozone crisis worsen given the country’s debt situation and the new Socialist government, while a resolution to the crisis should reverse the flows into perceived safe havens. Low yields not only encourage investors to take on more risk than they would otherwise wish as they search for yield, they also imply a deflationary future that would be intolerable for Western governments. Thus, in the US, the latest round of quantitative easing was the first to have occurred with little threat of deflation and Fed statements gave less weight to the control of inflation than usual. In the UK, Mervyn King suggested there was a trade-off between meeting the inflation target in the short term and reducing the risk of a financial crisis in the long run. It remains to be seen if this view is shared by his successor Mark Carney. Japan, meanwhile, is trying hard to create inflation.
Japan apart, equities delivered positive returns in Q3 driven by European Central Bank promises to backstop the bonds of indebted eurozone nations and the Fed’s move to open-ended QE. The size of our short duration positions in government bonds means we have little equity exposure in order to not double up risk in two correlated positions. Although equities are cheap relative to bonds, bonds are more expensive than equities are cheap. Instead, we access equity-like returns via convertibles, an asset class which occupies the middle ground between the bond area and the equity area and that we consider to be conservative equity. Convertibles can provide opportunities in difficult times due to their hybrid nature. This means they can offer an attractive asymmetric risk/return payoff by providing the upside potential of equities with some of the downside protection of corporate bonds.
The Jupiter Strategic Reserve fund has three currency positions. First, a short position in the South African rand. We are bearish on the rand due to the deteriorating labour and political situation in South Africa even as foreign investors shovel money into that bond market.
Second, a short in the Japanese yen. The likely winner of the recently announced elections, the opposition LDP party leader Shinzo Abe, has intensified pressure on the Bank of Japan to increase inflation, with a political interest to weaken the yen to support the ailing export sector. Third, a short in the Australian dollar, reflecting the overvalued status of the currency when growth is slowing in the mining sector.
Miles Geldard is head of the fixed interest and multi-asset team at Jupiter
In years to come, September 2012 will be remembered as one of the most eventful months in the history of monetary policy. The monetary injection from the Federal Reserve via QE3 and the reactive easing from the Bank of Japan were significant. The European Central Bank then compounded this by doing “whatever it takes” to stabilise European sovereign debt markets through Outright Monetary Transactions. For the eurozone, this could indeed be a game-changer in that it has bought politicians time to fix structural and fiscal issues while providing a platform for risk assets to continue their strong performance of 2012. The onus is now on the politicians to deliver.
In the US, housing activity is improving and the employment picture continues to make modest progress. Equities are also attractive relative to fixed income assets. Considering these factors, it is logical for multi-asset investors to cautiously increase their weighting to equities in 2013. The new administration in China is likely to want to make its mark with a stimulus programme that should benefit emerging market equities in particular.
Multi-asset investors must, of course, remain wary of potential headwinds as focus has now shifted to the fiscal cliff and its potential impact on US growth in 2013. While the ECB may have a newfound determination to save the euro, this has not prevented the region sliding back into recession. There are signs the recession is spreading to core eurozone countries and social unrest continues to be an escalating problem. With this in mind, multi-asset investors should ensure their portfolio remains diversified to absorb some of these potential shocks.
Ageing populations are now emblematic of developed economies and central banks are pinning down yields to historic lows, so investors should expect to see continued demand for income in 2013. It is unlikely, however, that corporate and high-yield bonds will see the unprecedented inflows of 2012. Credit spreads are approaching fair-value levels and demand for income could push yields to undesirable levels in 2013. While credit still has a role in multi-asset portfolios, investors should monitor traditional measures such as credit spreads when assessing their credit portfolios and also evaluate how much interest rate risk they are taking for a given yield level.
With yields at all-time lows, multi-asset investors should increasingly become more active in managing duration risk of their fixed income holdings. This naturally means esoteric asset classes such as loans and asset-backed securities will become more attractive. These tend to be less liquid than the traditional fixed income instruments with which retail investors are familiar. Therefore, only small exposures to these asset classes are sensible in multi-asset portfolios. Other asset classes that look attractive within diversified multi-asset portfolios are absolute return bond strategies, as they can deliver positive returns in both rising and falling yield environments, hence helping to reduce the duration risk of the overall fixed income allocation.
Finally, asset classes such as UK gilts, German bunds and US Treasuries undoubtedly look unattractive from a valuation perspective but they still have a role in multi-asset portfolios. At times of risk aversion, such asset classes have provided strong downside protection for multi-asset investors and this should continue throughout 2013.
History tells us it is notoriously difficult to predict what politicians and policymakers are likely to do, and their actions will continue to lead to short-term uncertainty in financial markets. Although there are potential headwinds, investors should remain optimistic that if policymakers can reach an agreement on the fiscal cliff, 2013 can be a constructive year for risk assets.
Justin Onuekwusi is a fund manager in the Aviva Investors multi-asset team