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Autumn's asset allocation

Autumn's asset allocation

Come early December all eyes will be on the Chancellor of the Exchequer, Philip Hammond, as he delivers his Autumn Statement. This annual act of economic window-dressing has always seemed seasonally out of place occurring so close to Christmas. So, for a truly autumnal outlook for the rest of 2016, we've decided to synthesise some leading investment research now. Possible themes as highlighted here by Morgan Stanley, Goldman Sachs and Credit Suisse may not necessarily help predict the direction markets take, but it is useful for smaller investors to at least keep an eye on what the big players are saying about core asset classes.

The first point to make is that major investment houses start from the position of a balanced asset allocation strategy. By having a broad range of exposures they hope to avoid the worst if an unexpected calamity were to befall financial markets. The positions institutions take are tactical deviations from the strategy - where they see the potential for higher relative returns in the short to medium term. It is in this context that research must be read. The focus is on problems and opportunities that might arise and encourage over- or underweight positions in asset classes over the next few months.

There may be other issues of importance - for example some of our readers are concerned about the possibility of a global oil price spike at some point in the future - but if the research teams don't view that threat as imminent, it is not discussed in detail. The salient point is that sensible asset allocation makes the portfolios ready for shocks and tactical positions are adjusted as portfolio managers deem appropriate.


The macro view

As data from Morgan Stanley shows, there have been negative indicators for US economic growth, including declining capital expenditure by US businesses. However, the consumer is in better shape and there is an upward trend forming in US industrial production. These are examples of the mixed messages economic data is giving and overall Morgan Stanley expects growth to disappoint, although it is more optimistic about the US than Europe and Japan.



Goldman Sachs has identified four possible scenarios for global investors over the coming years. The first is the 'Goldilocks' situation that occurred over the summer, with markets staying out of the clutches of the bears. Characterised by rising growth without higher bond yields and rising equity valuations, stocks that rise most with the market - ie those with a high beta - would be expected to outperform.

The second situation described is one of reflation - growth will rise but so will bond yields and although equities go higher, rising yields would cap valuations. A third (and worst case) scenario is stagflation - inflation concurrent with recession. If this occurred equities would derate and commodities outperform. This could be the scenario if, say, the oil price were to suddenly spike.

The most likely outcome in Goldman Sachs' view is a continuation of the current situation of fat valuations and flat growth that we have slumped back into since the Goldilocks rally.

One of the themes of both Goldman Sachs' and Morgan Stanley's research is the preference for the US over other developed regions. This is not the case for Credit Suisse, which points to low volatility in eurozone PMIs and strong domestic aggregate demand as reasons recent European growth should be resilient.


A secular adjustment in valuations

An area of consensus is the role high bond prices are having on equity valuations. As equities are riskier than assets such as government bonds, investors have higher expectations of share performance to compensate. This is known as the equity risk premium (ERP) over the return on risk-free assets such as government bonds. Historically, the global ERP has been around 3.2 per cent over US 10-year treasury bonds.

Looking back at the 20th century, when interest rates were higher, this implies investors required an exceptionally high nominal rate of return to invest in shares. This has struck many academics as curious and has come to be known as the 'equity risk premium puzzle'. Given the real annualised return on equities since 1900, investors should have been prepared to pay more for stocks or in other words more money should have been invested in shares.

The lack of return available elsewhere may, however, be having the effect of eliminating the ERP puzzle. The size of the premium itself is expected to be between 1 and half a per cent lower than in the past (according to estimates by London Business School academics Dimson, Marsh and Staunton), although it should still exist. With bond yields on the floor that implies the required nominal return from equities is nowadays much lower. The high price of many stock markets, even as lower earnings growth is expected, tells us investors are paying more for less. The impact of low bond yields has been to shift the equilibrium of stock market valuations higher and this is a central theme in the research papers we looked at.


Outlook and tactical investments in global equity markets

The re-rating of stock index valuations has primarily been driven by investors' flight to quality stocks and stable dividend payers in sectors such as utilities, which are being used as bond proxies to provide income no longer easily available from credit. This creates a dilemma for analysts as, on the one hand, quality and dividend stocks look expensive relative to the rest of the market and yet, on the other hand, in the absence of improving economic growth, it is difficult to forecast a re-rating for value stocks that have greater potential for further expansion in their valuations.

Partly due to this uncertainty, there are some divergences of opinion on the questions of which investing styles and sectors are likely to perform best over the coming few months.

Reflecting some slightly better data over the summer, we saw financials outperform for two months although, in the absence of a sustained improvement in the economic newsflow, Morgan Stanley sees limited scope for further equity re-rating and is not yet switching to more cyclical exposure. Its current play on euro area equities is to take profits on cyclical stocks and instead they are screening for defensive stocks where the trend in earnings is positive.

Overall, Morgan Stanley prefers US stocks to European or Japanese ones and still counsels reaching for quality and income. It identifies US healthcare stocks as having good quality credentials and also offering better value relative to other defensive sectors. While maintaining a bias towards quality, it does highlight US banks as an interesting proposition for value investors.

In the 'fat and flat' equity market scenario deemed most likely by Goldman Sachs, which is a continuation of the theme seen playing out over most of the past year, equities are unlikely to be driven higher by valuation, but are likely to benefit from some modest profit growth and an attractive yield. In this environment, equities grind higher (driven by some modest profit growth and cash returns to shareholders) in a relatively flat range while outperforming bonds. Generally, Goldman Sachs expects stable, defensive and low volatility growth companies to outperform. It also prefers the US to other developed equity markets.

Unlike the two US banks, Credit Suisse maintains a slightly overweight position in euro area equities. That's partly because it believes the market pricing of European equities seems overly pessimistic, with the implication of growth 3 per cent below the global average. Credit Suisse's own economists expect GDP growth in the euro area to be 1.5 per cent, so it believes European stocks are undervalued.

Potential areas of concern for Credit Suisse's positive position on European stocks include the outlook for the euro, although it believes it will remain resilient. Political developments may also be problematic with the Italian constitutional referendum in November and the French presidential election on the horizon.

The other slight overweight in Credit Suisse's equity allocation is its position in emerging markets. Emerging markets have been boosted by a number of factors since January, including: a fall of 8.5 per cent in the trade weighted index; a rebound in oil prices; the 30 per cent rise in the Credit Reference Bureau (CRB) metals index; and a drop of 58 basis points in the US Treasury inflation protected securities (Tips) yield. Credit Suisse believes some of these factors will become less supportive, but they still view emerging markets positively.

Again, Credit Suisse takes a different view to Goldman Sachs and Morgan Stanley when it comes to US equity strategy. It is more inclined to wind down some of the defensive and high dividend yield trades that have performed best over the past 18 months or so.

The principal concern is that valuations of defensive and income stocks look high both in absolute terms and relative to cyclical stocks and non-dividend-payers. Using fund flows as a barometer, Credit Suisse notes that outflows from cyclical sector funds are becoming less onerous and, simultaneously, inflows into low-volatility exchange traded funds (ETFs) are slowing. It also points to cyclical stocks being under-owned by hedge funds as a potential sign it is time for a change in direction.

Of course, there are risks to these views; if the US economy deteriorates, interest rates move lower and recession fears re-emerge, the outperformance of defensive and high yield stocks could resume.


Investments beyond equities

As discussed, an important reason equities remain relatively attractive as an asset class is due to the low yields on offer from fixed-income investments. To earn a higher rate of return, investors are forced away from sovereign bonds and towards corporate bonds (which are less liquid and have a higher danger of default) and also equities that pay a dividend to provide a level of income that is no longer available from government bond coupons.

Thanks largely to quantitative easing (QE) we have seen a far greater positive co-movement in the prices of shares and bonds than in the past. It is, however, still worthwhile having a degree of exposure to both asset classes and fixed income still plays a big role in the allocation decisions of the houses we reviewed.

Goldman Sachs notes that the recent concurrent rally of equities and bonds makes the job of pro-risk allocations harder going forward. This is why it has an overweight position in cash for the next three months, as it believes that bonds are unlikely to provide a good hedge for growth stocks and that prices in both assets would suffer from any rate shock.

Overall, though, Goldman Sachs remains neutral on sovereign debt but is overweight corporate bonds of short to medium duration. With its underweight position in equities, this is a rather defensive allocation for the near term.


Table: Goldman Sachs asset views for the 'fat & flat' scenario

Fat & flat - rates stay low and growth stays low
Market viewEquities drift higherEquity valuations stable
Sector viewStable growth and income stocks outperformDefensives beat cyclicalsBanks underperform
Regional viewUS outperformsEmerging markets do well


Morgan Stanley is also slightly overweight corporate bonds and rates US investment-grade debt as attractive as yields are good and, although overall leverage is high, interest cover (the ratio of earnings to debt payment obligations) is solid. In its cross-asset strategy European corporate debt is given a higher rating. Its preferred form of credit, however, is securitised loans. This may raise eyebrows given the role of mortgage-backed securities in the financial crisis, but as the hunt for yield intensifies if due diligence is done on such investments the fundamental principles of good-quality secured debt are sound. This point is academic anyway, as we are not aware of any existing ETF available for UK investors to invest in securitised debt.


Our 2015 portfolio outperforms by absolute and risk-adjusted measures

Last year, we put together a simple portfolio of ETFs and cash, to reflect our interpretation of some of the themes highlighted in the investment analysis of the big houses. The 11-month performance of the ETFs in the portfolio has been good. Overall, on a total return basis we are up by 10.8 per cent - just ahead of the FTSE 100 ETF, which made 9.1 per cent.

Admittedly, a single-asset index is not a true benchmark for a multi-asset-class portfolio, but it is a useful comparison to highlight the benefits of diversification. In today's low-yield environment an outperformance of 1.7 per cent is not to be sniffed at, but the really impressive part is the risk-adjusted performance. The diverse portfolio, which started out with a defensive 17.5 per cent cash holding, beat the FTSE 100 with only 8.4 per cent volatility. For the FTSE itself, there has been 17 per cent volatility over the same period.

A more appropriate benchmark for the portfolio last year would be the original 'balanced' asset allocation from Investors Chronicle's Ideal Portfolio series. This was split 60 per cent FTSE 100; 30 per cent gilts; 5 per cent gold and 5 per cent cash. Using the same ETFs we used for the multi-asset portfolio selected in 2015, the balanced benchmark portfolio would have returned 6.8 per cent with 9.7 per cent volatility.

The common measure used by fund managers to measure their risk-adjusted performance is the Sharpe Ratio. This subtracts a risk-free rate of return (usually the yield on 10-year government bonds or three-month treasury bills) from the portfolio return. These excess returns are the reward for taking on more risk; as risk is defined as the volatility of the portfolio, the Sharpe ratio divides excess return by this number to give the amount of return per unit of risk taken.

The average gross redemption yield for 10-year gilts over the period was 1.383 per cent, which enables us to calculate a Sharpe ratio of 0.45 for the FTSE 100 ETF. Although it underperformed the FTSE 100 in absolute terms, the balanced benchmark portfolio was better, adjusting for risk, with a Sharpe Ratio of 0.56. Once again, the star was our split-asset portfolio from 2015; its Sharpe Ratio of 1.26 was twice as good as the benchmark.


Reallocating for autumn 2016

Having not rebalanced the 2015 portfolio before now, the current allocations are as follows:

Asset class ETF (Ticker) Starting allocation (%) Weighting before rebalance (%)
UK large-cap shares iShares Core FTSE 100 (ISF) 7.57.39
UK mid-cap sharesVanguard FTSE 250 (VMID)7.57.27
European large-cap dB x-trackers Euro Stoxx 50 (XESC)12.512.3
US equitiesVanguard S&P 500 (VUSA)7.58.51
Japan equitiesVanguard FTSE Japan (VJPN)12.513.45
GiltsSPDR Barclays 1-5 Year Gilts (GLTS) 109.25
High-yield corporate bonds iShares Global High Yield Corporate Bond GBP Hedged (GHYS)109.66
Gold Source Physical Gold ETC (SGLD)55.03
Cash N/a17.515.87


Rebalancing the portfolio is a chance to revisit some of the allocation decisions from a year ago. The 15 per cent of holdings in UK equities (split evenly between the FTSE 100 and FTSE 250 indices) is an overweight position that would probably not be taken by leading institutions, but it is not a particularly outsized investment in our home stock market, so we keep it the same.

In light of some of the views expressed in the research we have studied, adjustments are made to other positions. In spite of the convincing case from Credit Suisse that European equities are cheap, given some of the headwinds (particularly political uncertainty) faced on the continent, we move to a slightly underweight position, with a 7.5 per cent allocation.

We make the same adjustment for Japan and use the freed-up capital to invest 7.5 per cent of the portfolio in emerging markets. As Credit Suisse points out, some of the factors behind the emerging markets recovery in 2016 could be less supportive going forward. That said, with weak growth dynamics in developed markets, it is worth having exposure.

Looking at fixed-income investments, with declining yields, it is time to switch into slightly longer duration and inflation-linked investments. We add the inflation-linked UK government bond ETF as it includes bonds with longer to maturity - offering a higher rate of return - and that also track inflation, for when weak sterling translates into a higher consumer prices index (CPI).

The duration of a bond in years is its effective maturity - the point at which the investor's required return is delivered. The longer the duration, the greater the risk that interest rate changes could alter the investor's required rate of return and the bond could fail to achieve its objectives within the portfolio. In a bond fund, duration is an important measure of the sensitivity of holdings to interest rates; a rise in rates will cause the price of the bonds held to fall, causing a capital loss for the fund. Adding to duration increases risk, so as well as taking allocation from the short-maturity gilts ETF and cash, we balance this decision by reducing the high-yield bond exposure to free up money for the new investment.

These tweaks to the portfolio are not huge - we are not out of any investment that we were in and we have added a broader exposure in global equities and fixed income. We have, however, ducked some of the macro calls thrown up by the research. The decision to keep equity investments tracking market-capitalisation-weighted indices is because, with an international scope, our portfolio should capture value where it exists globally, so there is no need to add risk to holdings in, say, the US by taking on a tilt with a factor ETF. With research split between anticipating a re-rating for value stocks and expectations that dividend and quality stocks will keep outperforming, it makes sense to keep to a market-capitalisation-weighted strategy.

Going forward, we will assume that we started with £100,000 in the portfolio last year, which would now be worth £110,788. The absolute size of the fund is one of the reasons we maintain a high allocation to cash. Keeping 15 per cent - £16,618 - in cash would be a reasonable amount to have to hand in a real life portfolio. If the fund was worth £1,000,000 then we would need to hold less cash because liquidity needs could be taken care of with proportionately less of the portfolio. In other words, our capacity to absorb risk is less with this smaller starting sum. How we choose to add risk will evolve as the portfolio hopefully grows and, on that subject, a scientific assessment of how alterations to this portfolio have affected its risk profile will be the subject of a follow-up article.


2016 adjusted asset allocation

Asset classETF (Ticker)New allocation (%)
UK large-cap sharesiShares Core FTSE 100 (ISF) 7.5
UK mid-cap sharesVanguard FTSE 250 (VMID)7.5
European large-cap dB x-trackers Euro Stoxx 50 (XESC)7.5
US equitiesVanguard S&P 500 (VUSA)7.5
Japan equitiesVanguard FTSE Japan (VJPN)7.5
Emerging market sharesiShares MSCI Emerging Markets (EMIM) 7.5
GiltsSPDR Barclays 1-5 Year Gilts (GLTS) 7.5
Inflation-linked giltsiShares £ Index-linked Gilts (INXG) 10
High-yield corporate bondiShares Global High Yield Corporate Bond GBP Hedged (GHYS7.5
GoldSource Physical Gold ETC (SGLD)5


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By James Norrington,
30 September 2016

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