Asset Allocation after the Market Bonanza
We believe we are entering a new, less directional phase in the market, where more relative value approaches will be key in generating alpha1. Low inflation, a stronger dollar and a normalisation of interest rates in the US will be, in our view, the key themes in 2015.
The year 2014 went down as the fifth straight year of bull markets after the great financial crisis. Despite multiple headwinds at the beginning of the year, such as the risk of an interest rate rise and its impact on the market, investors have actually enjoyed positive returns across multiple asset classes. Volatility has also been limited, despite increasing of late, and asset allocation has generally been driven by the directional trends.
However, things seem to be changing. The macroeconomic scenario is becoming more challenging and some bullish trends in financial markets are maturing. At the same time, geopolitical tensions and deflation risks could see volatility return. Therefore, we believe that a new, less directional approach to multi-asset investing will be key in navigating markets in the years to come.
Time to be Less Directional
In the current environment, we believe no asset classes are cheap on valuation grounds, but factors such as Central Bank monetary policies – including the likelihood of further quantitative easing in Japan and Europe – are likely to continue to support markets. Balancing these considerations, we continue to favour a moderately positive view on equities.
However, our asset allocation approach will likely differ from that of 2014. While taking a directional view seemed appropriate in 2014, a focus on relative value is likely to be more appropriate in 2015. For 2015 we foresee three major macroeconomic themes that will guide our asset allocation. These are low inflation, a stronger dollar and the US Federal Reserve’s decision to begin tightening monetary policy by raising interest rates. We think all three are likely to have significant implications for markets and must be taken into account when constructing a multi-asset strategy.
Low Inflation is No Detriment to Real Returns
While there is still significant concern over the possibility of deflation, especially in Europe, this is not our central scenario. Instead, we anticipate an environment of low but positive inflation.
Historical data suggests this environment is likely to be positive for many asset classes. An analysis of S&P 500 returns since 1872 suggested that periods of low inflation or mild deflation were associated with attractive real returns for equities, on average.
But who could be the winners in a “lowflation” environment?
We believe equity and credit markets where Central Banks are likely to embrace looser policies than their peers – such as Europe– are particularly likely to be beneficiaries.
Other strategies that could benefit include income-related themes, such as within the Japanese equity market, where dividends have been moving up. Regions with fiscal policy flexibility or credible signs of reforms could also be attractive, such as Chinese and Indian equities.
The US Dollar could be set for Long-Term Appreciation
Even after the recent rally, the US dollar remains well below its long-term value on a trade-weighted basis. This implies to us that the dollar is likely to continue strengthening, given the relative strength of the US economy versus much of the rest of the world. Historically, US dollar trends tend to be relatively long-term; thus the current up-trend could last.
Potential beneficiaries of this include US equities, especially the more domestically focused names. Less obviously, we think this is likely to be a further tailwind for Japanese stocks, since a stronger dollar inadvertently can assist the Japanese Central Bank’s efforts to depreciate its currency, providing a boost to export earnings in local currency terms.
Possible losers in a stronger dollar scenario include energy and other commodities, as we have already seen in oil and some industrial commodities. We believe emerging market assets are also likely to come under pressure, as has already been demonstrated by the “taper tantrum” of mid-2013. During this time emerging market currencies fell sharply as it became clear the Fed was preparing to begin winding down its QE policies and that the carry from holding emerging market currencies would diminish.
Past experience also suggests that emerging market currency volatility can act as a transmission mechanism for increased selling in other emerging market asset classes, in part because it may encourage foreign investors to retreat from these markets and repatriate their investments into other asset classes, such as US equity. Consequently, we believe there is a risk of increased volatility in emerging market equities as the strong US dollar trend becomes more established.
A Fed Hiking Environment
Lastly, we believe the likelihood that the Fed’s first interest rate hike will occur in 2015 means it is now important to focus on the US interest rate cycle. This contrasts with other parts of the world, where structural considerations remain more important.
We envisage a number of potential scenarios for the US, depending on the potential growth path and the trajectory of interest rates (see table).
In what we see as the most likely of these scenarios (normality), the most favoured asset class would continue to be equity, while the outlook for fixed income would be largely negative. Lower grade credit, those with ratings below BB, are likely to struggle in an environment of increased US yield curve volatility. We think US real estate investment trusts, which have performed well in recent years, may also be due for some consolidation.
The scenarios in which equity could suffer appear less likely to us. These include a policy mistake, in which the Fed raises interest rates while both growth and inflation remain low.
A scenario of lower growth and rising inflation would also provide headwinds for equities, but this appears relatively implausible given prevailing macroeconomic fundamentals.
How to Navigate Markets in 2015
All in all, we maintain a constructive view on risky assets. However, significant risks and uncertainties in global markets remain. This means focusing on risk management and seeking to protect investments against tail risks remain an important part of a multi-asset strategy.
We believe that geopolitical tensions have the highest probability of impacting markets over the next 12 months. Conversely, the likelihood of other risks, such as a credit crunch in China, has significantly diminished and can be considered a low-probability threat at present. European deflation, rising currency and emerging market volatility driven by Fed tightening, are presently medium-probability risks that should be monitored carefully.
Another escalating risk is the danger of other countries responding to the depreciation of the yen with reciprocal currency devaluations intended to remedy any potential loss of competitiveness. We assess this as only a medium probability at present, but recent trends indicate that the risk may rise in 2015. Consequently, this is a potential development to which all investors should pay close attention.
In conclusion, considering our three major economic themes for 2015 – low inflation, the strong dollar and rising US rates – we believe a moderate risk-on approach that favours equity to be the most appropriate means for generating alpha. In our view, successful multi-asset investing will require a strong focus on finding relative value opportunities among and within asset classes. Hedging against tail risk will remain key, as multiple headwinds are still blowing.
1 Source: IMF, data refers to the estimated Nominal GDP for 2014. Data as of November 30, 2014.