Overweight developed versus emerging markets
Although there has been a slowing of US economic momentum, economic growth expectations continue to improve in developed markets while within emerging markets there is significant divergence.
Some countries, such as Brazil, have less than desirable inflation and structural dynamics while other countries, such as Turkey, have concerns over external debt levels.
Slowing growth has been a feature of many emerging markets, particularly China, which is the largest constituent within the emerging market bloc. In contrast, the economies of developed markets are in a recovery phase. Improving growth prospects in most areas are providing a positive environment for equity market returns.
The US has led developed markets on the path to recovery followed by the UK. Meanwhile, Japan has experienced a pick-up in growth momentum since the emergence of Abenomics. We expect the relative outperformance of developed versus emerging markets to continue while emerging economies continue to struggle.
Underweight position in government bonds
Having started the year above 3 per cent, 10-year gilts have moved consistently lower and now stand close to 2.6 per cent.
This was largely early in the year when slightly weaker UK data, coupled with weather-affected US data, led the market to worry as to whether the nascent recovery in developed markets was at risk. We do not believe this to be the case and that rates will rise as recovery takes hold and central banks seek to “normalise” rates. We have therefore positioned our portfolios to be underweight both government bonds and index linked bonds.
In the UK, economic data continues to improve and consensus expectations are for the Bank of England to begin raising interest rates in early 2015. Although the Bank of England should have some flexibility as to when they need to move on rates, with inflation surprising on the downside during the first quarter, lower than expected UK CPI, the continued strength of sterling and benign commodity prices, there are few near-term risks to inflation.
Furthermore, in the US, quantitative easing tapering is well underway and the Federal Reserve indicated that the median forecast for interest rates at the end of 2015 is 1 per cent. Given that the Federal Reserve is viewed almost as the global central bank, its actions can have a significant impact on global policymaking.
Overweight position in UK real estate
We are firmly overweight in UK commercial real estate, where three-year forecast returns remain favourable relative to other asset classes such as cash and government debt.
Rents continue to rise particularly strongly in Central London and the gap is narrowing between regions. Void rates are also declining, with much of the reduction in the industrial and office sectors. Investor inflows, the pick-up in economic growth and increased institutional appetite are also supporting real estate.
We have increased our forecast for total returns to 9.5 per cent per annum for the next three years, with 6 per cent coming from the yield element and the remainder from an increase in capital values.
Bambos Hambi is head of fund of funds management at Standard Life Investments