Architas chief investment officer Caspar Rock explains why he’s backing longer-dated bonds and considers the implications of the UK potentially leaving the EU this year.
Long duration assets
Despite the strong run in gilts, especially very long-dated ones, duration in fixed income portfolios is still a vital means of diversification. The markets remain fixated on the prospects for inflation and the outlook for short-term interest rates.
With oil prices recently touching 12 year lows and deflation stalking developed economies, central banks are at great pains to convince the markets they will take any action necessary to restore inflation and inflationary expectations.
On the back of this, long duration assets continue to perform well despite the naysayers questioning the downside risk compared with the limited upside potential returns.
We continue to have more duration in our fixed income exposure than peers, although less than benchmarks. Longer-dated bonds may be expensive to certain investors but they should provide some protection against equity market volatility if it arises.
Quantitative easing programmes have been adopted by central banks across the developed world in an attempt to encourage bank lending and economic growth or reduce the pressures of austerity. The one glaring, if unintended, consequence of this action has been to push up the price of all sorts of assets and to increase correlations of asset classes.
It is difficult to know whether portfolios are truly diversified until after an event has happened. However, this should not stop you considering the underlying drivers of return in your portfolios. If you have sophisticated risk management tools at your disposal, use them to see if you have unintended biases.
We continue to use yielding alternative assets, in particular real assets such as specialist property and infrastructure in an attempt to mitigate some of this correlation risk. This has improved the Sharpe ratios of our portfolios in recent years.
As we approach the EU Summit on 18 February, speculation is mounting as to whether or not David Cameron will achieve the renegotiations necessary to launch the Brexit referendum, which could take place as early as June this year. It is difficult to see any positives regarding an exit from the EU, as the regulatory dividend seems insignificant relative to the scale of economic and political turmoil that would ensue.
The negative impact of a Brexit on UK GDP is estimated to be as much as 7 per cent over the next decade or so.
The uncertainty over the eventual result is going to make this a difficult year for sterling as a currency and sterling equities. As opinion polls swing either side of a close call over the next few months we have anticipated this volatility by reducing exposure to UK equities and raising our foreign currency holdings as a partial hedge.
Caspar Rock is chief investment officer at Architas