Tactical Asset Allocation update: Q3 2021

Asset class

Q3 2021 Score

Direction of travel

Commentary

Overall

4

↓

Overall, we remain positive on risk assets but acknowledge challenges to this view, from growth disappointments (particularly countries struggling to meet aggressive predictions) to future Covid-19 mutations. There remain plenty of positive impetuses, with pent-up corporate and consumer demand still being released, vaccine distribution continuing (albeit with many Asian countries lagging), and monetary and fiscal policy still supportive.

While central banks are discussing tapering asset purchases this year, they have stressed interest rate rises are still some distance away and continue to insist current higher levels of inflation are transitory.

Although aggressive tightening is not on the agenda, the world needs to get comfortable with a new status quo where crisis-level monetary policy is no longer essential. Assuming vaccination efforts continue and the pandemic recedes, we see the global economy moving into a mid-cycle expansion, with the focus shifting from recovery to more sustained growth.

Following recent peaks in policy support, growth and markets, we would expect to see global GDP moderate to above-trend levels next year and more active stock selection will be required in such an environment, with the broad rally since last year’s vaccine announcements thinning out.

Cash

1

↓

Cash offers little to no prospect of a real return in the coming years, with major central banks remaining committed to loose policy. Cash does have the benefit of offering a store of value at times of market stress, so a modest allocation may be appropriate depending on the mandate.

UK gilts

2

↑

Yields have risen off their extreme lows in recent months and we moved slightly more constructive on gilts in our Q2 TAA review. This asset class remains underwhelming overall, however, with the bias of risk continuing to be to the upside (or to the downside in price terms), especially if higher inflation persists. Gilts still provide a useful function as portfolio insurance in times of market duress but offer little more than a cushion to equities.

Global government bonds

2

↑

A global basket of currencies and interest rate risks can result in a differentiated return stream from UK gilts. Yields remain close to all-time lows and the bias of risk looks to be to the upside (or the downside in price terms), especially if higher inflation persists. These bonds still provide a useful function as portfolio insurance in times of market duress but offer little more than a cushion to equities.

Investment grade (IG) corporate bonds

3

↑

We have increased our rating on investment grade credit from two to three, in recognition that spreads versus government bonds offer a reasonable yield pick-up while providing strong credit quality. In times of market stress, this debt should also benefit from its inherent duration.

Index-linked bonds

3

↑

This debt would benefit versus nominal government bonds if inflation proves to be ahead of expectations, although the possibility of higher prices is now more widely anticipated than it was last year. Index-linked bonds tend to have longer duration than the same tenor nominals so duration positioning needs to be considered. Big moves out in yields will also impact these bonds. It is best to buy inflation protection when the risk is underappreciated, which is not the case today.

High yield (HY)

3

↓

While still overweight high yield, as the overall risk-on environment should be supportive of prices, we believe moves in spreads year to date make these bonds relatively less rewarding for their level of credit risk and have therefore moved our rating down from four to three.

Emerging market debt (EMD)

3

↑

Spreads look reasonable but the idiosyncrasies of the emerging market environment are potentially better rewarded in EM equities. Furthermore, US dollar- denominated debt will be subject to moves in the US yield curve. There is some potential for support from a softer US dollar, better liquidity than expected, and carry hunters.

Convertibles

4

↑

The composition/concentration of global indices is a negative, as are valuations. But a positive overall market backdrop supports convertibles, which provide an attractive risk/return profile thanks to their optionality and the bond floor.

Equities overall

4

↓

The risk-on environment continues to favour equities. Markets have come a long way from the 2020 lows but this is largely justified by government spending and decent corporate results.

More recently, market leadership looks to be shifting back towards growth, away from the value and cyclicals that have driven most of the rally this year. We would caution against immediate assumptions the value rotation is over, however. In valuation terms, value still looks attractive, despite the recovery this year, while many growth sectors remain expensive, particularly the mega-cap end of the US market.

As we have always stressed, the case for longer-duration growth companies builds in assumptions looking far into the future and many could be vulnerable to changing conditions; if investors are concerned about rising government bond yields, that caution should extend to overpriced growth equities.

Meanwhile, value has underperformed for many years and we feel the recent recovery may ultimately prove the first leg of a multi-year retrenchment.

US equity

3

↑

The US is a formidable market with a strong entrepreneurial culture and a roster of world-class companies. From a policy perspective, the Federal Reserve looks set to be first off the blocks with tapering but assurances that rates hikes are still way into the future appear to have prevented a 2013-like tantrum for now.

Valuations look elevated for the index overall, although the picture is better outside of mega-cap growth. A shift back towards ‘real world’ rather than virtual interaction will put pressure on technology revenues and, overall, share prices have discounted better-than-expected earnings.

US small caps

4

↑

Despite our overall caution on the US, we see smaller companies as ripe for a rebound in light of their significant underperformance versus large caps. As the recovery broadens, investors will be looking elsewhere and consumers flush with cash should benefit domestically orientated companies, especially small caps. As the economy reopens (we are bullish about the cycle), small caps should outperform large. A risk to this would come from tax hikes, which tend to hit small and mid-cap companies more than their larger counterparts.

UK equity

4

↑

The UK was hit from all sides in 2020 with Covid impact, sector composition (heavy in struggling resources, financials and energy), and Brexit combining to make it the most unloved major market. Despite its global revenue base, there is too much pessimism in the price so, tactically, this is an attractive market. A strong pound is likely to be a headwind, however.

UK small caps

4

↑

A strong rebound in UK smaller companies is already under way but there is further scope for mean reversion with Brexit uncertainty disappearing, sterling normalisation and further merger and acquisition (M&A) activity. Enhanced economic activity thanks to vaccine rollout should also provide impetus to domestic-orientated names.

European equity

4

↓

Europe’s vaccination effort continues to improve and the region has been a major beneficiary of a global recovery and normalisation. Export-led European stocks are geared into a global recovery and consumer brands should benefit from high levels of spending power turning on post lockdown. Overall, valuations look attractive and Europe is further along the environmental, social and governance (ESG) path on a company by company basis than other markets.

European small Caps

4

↑

European small caps are under similar pressures to their larger counterparts but should be well positioned to take advantage of global reopening and increased domestic consumption on the continent. Prospects would come under pressure should governments accelerate their plans to balance the books.

Japanese equity

4

↓

Japanese equities, with a large proportion of export-driven businesses, are well placed to benefit from the global economic rebound. Questions nag in the short term over the ability of the economy to recover its stride as vaccine rollout lags other developed markets. Japan remains lowly valued compared to other developed markets. Exporting stocks tend to benefit from yen weakness so local currency strength could provide a headwind to returns.

Japanese small Caps

3

↓

Japanese small caps are under similar pressures to their large counterparts but should be well positioned to take advantage of global reopening and increased domestic consumption.

Emerging markets equity

4

↓

Emerging markets will benefit from the global reflation trade, with loose monetary policies and a weak US dollar also providing a supportive environment. Long-term fundamentals remain intact but shorter-term pandemic shocks, with generally slower vaccination rates, and recent policy shifts in China, as the state aggressively reins back certain sectors, continue to hit sentiment. EM equities remain highly geared into sentiment shifts – both positive and negative – and are also highly sensitive to domestic and international politics.

Asian equity

4

↓

As with EMs, Asia is benefitting from the reflation trade and loose monetary policies and a weak US dollar also provides a supportive environment. These economies have, on the whole, fared well through the Covid crisis but slower vaccination rates and China’s recent moves against sectors such as tech have hit sentiment. Risks remain from the perspective of global sentiment as well as regional political tensions.

Property

3

↑

Property offers a reasonable yield pick-up compared to many other asset classes and price moves in 2020 imply that a lot of bad news is already factored in. Capital values are starting to rebound but rental growth is decelerating. There is also uncertainty surrounding a number of property types in a post-Covid world: the anticipated demise of the office and high street retail sectors could well be overstated but current pressures on tenants will have long-term repercussions.

Commodities

3

↑

Commodities have rebounded strongly off their lows and are not as attractive a value play today. Over the medium to long term, they should remain correlated to continued positive news on global economic activity. Broad allocations to commodities should also provide some protection if inflation surprises on the upside. Conversely, downward price pressure could resume if growth disappoints following the initial post-Covid recovery.

Hedge funds

3

↓

Given time, the right hedge fund strategy can provide a diversified return stream compared to more traditional asset classes. These funds are unlikely to keep up with a raging bull market but should post reasonable returns in a constructive environment for risk assets.

Absolute return

3

↓

Well-chosen absolute return vehicles can be a useful diversifier to overall portfolio risk thanks to their low correlation with traditional asset classes. But they are unlikely to keep up with ultimate safe havens such as government bonds in times of market duress.