Sharp falls in equity markets, as were seen in August 2015, can understandably spook investors and create uncertainty. For two of the world's large investment houses, however, the late summer sell-off was a buying opportunity and not a signal to revise longer-term outlooks that remained broadly bullish, for risky assets such as shares. Fast forward to early October and rising markets seem to be vindicating these generally positive views. As we reflect on the attractiveness of asset classes and ponder portfolio allocations, it's helpful to revisit some of the research from Goldman Sachs and Morgan Stanley that has been published since July.
Equities
In its H2 2015 outlook from July, Goldman Sachs gave a confident prognosis for global economic growth and was overweight in its allocation towards equities. Within the asset class, the preference was for European and Japanese shares over the United States, where the S&P 500 offered less value. China's slowdown was on the radar but Goldman Sachs was not panicking, maintaining a stable outlook for Asia ex-Japan.
The factors cited as being supportive of European shares were the weaker EURUSD exchange rate; the ECB's continuation of its quantitative easing programme; and an acceleration in GDP growth. The expectation was that once the latest impasse was breached in the Greek debt crisis, better growth figures were well balanced with political risk. Goldman Sachs opined that Japanese equities would be driven by rising wages, consumption, and capex recoveries, positive earnings surprises and buying from corporate foreigners and the Bank of Japan.
The view from Morgan Stanley in its more recent Cross-Asset Dispatches, published in mid-September, after the volatility spike, was also bullish. Pointing to encouraging eurozone purchasing managers' index data, the favourable EURUSD exchange rate and an attractive valuation for Germany's DAX index, European equities were one of its favourite assets on a six- to 12-month horizon. With Japan's TOPIX (a cap-weighted index of the First Section of the Tokyo Stock Exchange) trading on attractive forward earnings multiples, even in anticipation of 18 per cent earnings growth this year, Morgan Stanley was overweight in its allocation here, too.
Bonds
With a definite tilt towards equity markets in their allocation positions, both Goldman Sachs and Morgan Stanley are overall underweight-to-neutral in their exposure to debt securities. Goldman Sachs was underweight government debt but marginally preferred German bunds to US Treasuries. The position on corporate debt was neutral, although within this asset class, a preference was indicated for US high-yield versus US or European investment grade bonds. Morgan Stanley went further, highlighting that US high-yield bonds are well-positioned, in anticipation of a more dovish stance from the US Federal Reserve on interest rates.
Commodities
Unsurprisingly, commodities have been a major underweight position for 2015. In July, Goldman Sachs said that following a decade of high capital expenditure, there was a secular bear markets in oil and industrial metals. With regards to the impact on other asset classes, it pointed to the low oil price having been taken as a sign of weak growth in the second half of 2014, with the effect on equities of cyclical sectors underperforming defensives. As Goldman Sachs believes that the downward pressure on commodities prices comes largely from oversupply, it did not expect prolonged equity underperformance and was overweight on cyclical sectors and financials.
In a very recent note in October, however, Morgan Stanley put forward the view that the low sentiment and consequently attractive relative valuations towards broad commodities made for a buying opportunity. In anticipation of an inflection in macro sentiment, it was increasing its exposure.
Reasons to remain sanguine
Since surviving, what seemed at the time, a situation that verged on financial Armageddon in 2008-09, capital markets have proved robust in the wake of numerous shocks and crises. Morgan Stanley was of the view that, rather than being the sign of another major cyclical turn such as in 2008, the late summer volatility of 2015 had greater similarities with spikes that occurred in 2010 (Greece), 2011 (US debt ceiling), 2012 (eurozone) and 2014 (Ebola). It reasoned that, in September, no country or major company defaulted, no central bank drastically altered its course of action and no economic data disappointed dramatically. The big stories, of slower Chinese growth and the Fed rate hike, were on the horizon and already priced in. Furthermore, the volatility in equities was not matched in credit or foreign-exchange markets, encouraging Morgan Stanley analysts that there was an absence of some key indicators of a change in cycle.
Asset allocation plays for the rest of 2015
The global asset class views written by Goldman Sachs and Morgan Stanley are not investment advice and are certainly not meant for a retail investor audience. They do provide a useful backdrop of information and analysis for ideas in Investors Chronicle. Taking the Investors Chronicle Ideal Portfolio as a starting point, it is possible to build our own tactical asset allocation model using exchange traded funds (ETFs). The 2015 IC Top 50 ETF selection, provides a readily vetted universe of products to choose from.
| Asset | Position | ETF | Ticker |
|---|---|---|---|
| UK Equity | OW/OW | iShares Core FTSE 100 UCITS ETF | (ISF) |
| UK Equity Mid-Cap | OW/UW | Vanguard FTSE 250 ETF | (VMID) |
| Europe Equity | OW/OW | Dbx-trackers Euro Stoxx 50 UCITs ETF | (XESC) |
| US Equity S&P 500 | OW/UW | Vanguard S&P 500 UCITs ETF | (VUSA) |
| Japan Equity | OW/OW | Vanguard FTSE Japan UCITs ETF | (VJPN) |
| Asia ex-Japan Equity | OW/N | Dbx-trackers MSCI AC Asia Ex Japan | (XAHG) |
| UK Sovereign Debt | UW/UW | SPDR Barclays 1-5 year Gilts | (GLTS) |
| International Sovereign Debt | UW/UW | Dbx-trackers II Global Sovereign UCITS ETF | (XGSG) |
| Investment Grade Corporate Debt | UW/UW | iShares £ Corporate Bond 1-5 yr UCITs ETF | (IS15) |
| High-Yield Corporate Debt | UW/OW | iShares Global High Yield Corporate Bond GBP Hedged | (GHYS) |
| Money Market Proxy | N/N | iShares ultra-short Bond UCITs ETF | (ERNS) |
| Gold | UW/UW | Source Physical Gold ETC | (SGLD) |
| Broad Commodities | UW/UW | Lyxor UCITS ETF | (CRBL) |
| Property | N/N | HSBC FTSE EPRA/NAREIT | (HPRO) |
The 14 products listed, plus cash, can form the building blocks of a well-diversified portfolio and provide variation within the broad allocations of our Ideal Portfolios. Unlike the similar 10 asset ETF portfolio (see 'Rebalancing Perspective', 17 Apr 2015), the allocations will not be equal-weighted and there is no assumption made that this portfolio will constantly be invested in all of the ETFs listed. Rather, these products can provide a play on opportunities as they are deemed appropriate.
Starting strategy
The Investors Chronicle Ideal Portfolios are split into cautious, balanced and adventurous allocations. Since 2006, back-testing of the balanced allocation has performed the best in absolute terms and relative to risk, so it makes sense to use this as a starting point. The balanced strategy is a simple (50:40:5:5) split between shares, bonds, gold and cash respectively. Being overweight in shares, this allocation is in keeping with the positive outlook for global equities in the institutional analysis we have studied. To increase diversification, sub-allocations can be made within these broad asset classes.
To reiterate, the analysis of large institutions is not aimed at a retail audience. So, in this balanced portfolio tactical asset allocation, it is important to try instead to adopt the perspective of a UK private investor. This means a domestic bias within the equities and fixed income investments and also a flexible approach to using cash as a reserve asset. Institutional investors are under far more pressure to be constantly invested in risky assets to outperform their peers and in most cases are looking at a longer time horizon to achieve returns and recover any losses. A private investor has less capacity to sustain or make good on losses, so it makes sense to hold more cash or cash equivalents.
UK equities make up 15 per cent of the total portfolio and there are 12.5 per cent allocations each towards European (ex UK) and Japanese shares. There is also a 7.5 per cent investment in the S&P 500. These splits reflect the views of the institutional studies that European and Japanese stocks are more attractive than the US but still gives decent exposure to the world's largest equity market.
Looking at fixed income, 10 per cent of the portfolio is in UK government debt which forms the entirety of the investment grade bond exposure. With low interest rates a global phenomenon, holding cash is a more cost-effective way of reducing overall risk than buying ETFs in lots of different high-quality government bonds or money markets. A further 10 per cent is taken from the bonds allocation and placed in property. Another 10 per cent is invested in Global High-Yield credit markets to try and achieve higher returns from riskier debt.
There are some markets and asset classes that are avoided entirely for now. Based on positive early indicators of a turnaround, investment houses might choose to alter neutral or underweight positions in emerging markets and commodities, to overweight. For private investors, however, it makes more sense to wait until there are clearer signs of an uptrend. Weakness in emerging markets and commodities should not continue indefinitely but for asset classes that are not core portfolio holdings, it may prove prudent to sit on the side lines for now. In any case the large-cap equity holdings give exposure to the commodities sector, for example big mining companies, so this selection would not completely miss out on gains if there is a bounce in prices in the fourth quarter.
Timing trades
There are systematic ways to decide when to enter or exit an investment, for example using momentum-based rules. One such method might be to sell a position every time the asset ends a month below its 10-month moving average price and buying back once it posts a monthly close above it. The problem is that in a highly volatile period for equity markets, such methodologies could result in whip-sawing in and out of positions at exactly the wrong time; racking up costs, missing upside and catching corrections.
For now, the simple allocations described keeps costs down and gives broad exposure to developed market equities, plus further internationally diverse risk-reward plays in property and high-yield corporate bonds. Positions in UK government bonds and cash should help protect against drawdown (market falls) and, in the case of the latter, provide flexibility to add more risk to the portfolio as desired. For now, though, it will be worth taking cash dividends where applicable, to add to the cash pile ahead of a review in January 2016.
