There comes a point when the equity rally begins to feel long in the tooth. This can be salved by a look at corporate figures – earnings stay robust, balance sheets are strong and with the MSCI World Index trading on less than 12 times 12-month forward earnings at the end of March – well below the 20-year historical average of 16 times – valuations are far from excessive. There is still plenty of opportunity for the markets to make progress, particularly if the recent bout of economic strength in the US can take root elsewhere.
However, if the markets have taught us anything in the past few years, it is complacency can be very damaging to wealth. Surprises tend to occur at the moment we feel comfortable. It seems only reasonable to try and build some natural hedges into a portfolio.
The first and most simple strategy is to go for quality. Numerous factors that might trip up the US economy, from record-high gasoline prices for this time of year to worries that the strong US non-farm payrolls figures may owe as much to warm weather as to genuine labour market strength, but it seems foolish not to have exposure to the world’s biggest economy. The US has proved relatively robust in recent years as reflected in 10 consecutive quarters of economic growth. Its capacity to innovate, a flexible labour market and responsive and proactive authorities with the benefit of the world’s reserve currency are all factors that support exposure.
Proactive central bank policy has also caused us to favour Japan. Only last month, the Bank of Japan expanded its asset purchase programme and pledged to target an inflation rate of 1 per cent to help defeat deflation. Japanese equities have had a strong first quarter but valuations remain near historical lows, with the MSCI Japan trading on less than 14 times 12-month forward earnings. With the country rebuilding after last year’s earthquake there remains a domestic secular drive to the economy to complement exposure to global trade. We expect the BoJ to be more responsive to holding the yen in check, which would help exporters that last year were struggling from a combination of an elevated yen and supply chain problems due to floods in Thailand.
From a geopolitical perspective, the Middle East remains an unknown. A small exposure to oil offers some hedge against tension.
Government bonds offer a hedge against the equity rally fading but with yields on core UK, US and German 10-year sovereigns hovering around 2 per cent, the upside from downside is increasingly strained. Better long-term value appears to be offered by the credit markets and the US dollar, although sovereigns have had an uncanny knack of beating expectations. The most effective way to defend against the unexpected is to have a diverse portfolio.
Bill McQuaker is head of multi-manager at Henderson Global Investors