Renewed concerns over a potential Grexit means the eurozone is once more a focus of attention. This has driven some significant volatility recently. I took the opportunity afforded by a sell-off in equity prices to modestly increase our exposure to European equities. Europe is now the largest equity allocation in the fund, a significant change versus 12 months ago when we had zero exposure to European equity.
This time last year I still felt that, although valuations were compelling, the fundamental risks in the eurozone economy were still too great for a reasonably conservative fund like mine. However, over the past year, fundamentals have improved significantly, with earnings being revised upwards in several areas.
Moreover, recent action taken by the European Central Bank to support European growth, including a massive quantitative easing programme, should provide further confidence in the outlook for the overall economy. However, it is important to remember that there are still very real risks in the eurozone and investor sentiment remains fragile. Caution is therefore required and, in making any investment decisions, I will always weigh price observations against the fundamental analysis. However, should we see further bouts of volatility that looks inconsistent with the fundamental picture, my predisposition would be to increase, rather than cut, European equity exposure.
I have also been meaningfully adding to the fund’s basket of US bank stocks. Although US equities have broadly performed very well during the past couple of years, the banks sector remains particularly attractively valued. Furthermore, banks have historically tended to benefit in a rising rate environment. So, as an interest rate rise by the US Federal Reserve looks increasingly likely later this year, I believe these holdings should provide a good interest rate hedge.
Non-mainstream government bonds
I believe the legacy of the 2008 global financial crisis has seen investors demand so-called “safety” at any cost in recent years. This has driven mainstream government bond yields to historic lows that have become increasingly difficult to justify as economic recovery in developed economies has been gathering pace. Therefore, since significantly reducing the fund’s mainstream bond holdings over 2014, I have for most of this year only maintained a very modest holding in US treasuries as “insurance”. My preference has been for higher yielding non-mainstream bonds issued by countries where fundamentals are supportive, such as Australia, New Zealand, South Africa, the Philippines and selected Latin American countries, and have recently added a holding in Italian bonds.
Recently, however, volatility in mainstream bond markets means yields have risen to somewhat more attractive levels. As such, I recently added a holding in German bunds and continue to watch the bond space carefully for further opportunities to increase the diversification of my fixed income allocation.
Steven Andrew is manager of the M&G Episode Income fund