As economic data globally appears to be outpacing expectations, investors could be seduced into thinking that financial markets are about to embark upon a pretty impressive bull run.
Indeed, the recent sell off in government securities could be a confirming indicator that monetary policy is about to begin a phase of tightening bias, to reign in nascent inflationary forces.
The multi-manager team at Schroders has some sympathy with this view, but not perhaps in the manner that would be expected. The expectation that real interest rates are in a tightening cycle is something that we agree with.
Typically, that means a weak return for interest rate sensitive assets such as government bonds, where we have a zero exposure.
Clearly, every portfolio should have some assets that protect capital in weaker markets and, to us, most bonds fail to provide that safety, so we are at our highest cash levels ever. To many observers, this would mean that we are constructing extremely bearish portfolios, five years on from the bankruptcy of Lehman, but in reality it is a direct expression of our view of the risk/reward offered in traditionally safe area of fixed interest assets –bonds.
Conversely, we are very attracted to the valuations on offer from European and Japanese equity markets. The common theme here is that investor sentiment towards these markets is too bearish.
Many are still very concerned about the possibility of a financial relapse in the eurozone, something that we do not dismiss. However, in our opinion, valuations reflect a large part of this risk, but they do not reflect the recent economic pick-up.
Our call here is not that the European economy comes roaring back, rather that it becomes “less bad” – which is a lot better than current valuations suggest is the likely outcome.
The story in Japan is becoming much better understood by the market, but it has failed to make up the massive under-performance of this region over the past five years.
Prime minister Shinzo Abe and his colleagues appear determined to weaken the yen, which has been a tremendous headwind to such an export-dominated economy.
Truly global champions such as Panasonic, Sharp, Sony and so forth have been undermined by competition from their Chinese, Taiwanese and Korean neighbours, but perhaps this will now change since the yen has depreciated.
Financial markets have delivered decent returns since 2009 and 2013 is indeed on course for another good year. Investors’ portfolios need to reflect the changing risks and valuations that have occurred.
Safe assets – government securities – and safe markets – US equities – appear very fully valued in our opinion and therefore could provide an unexpected source of disappointment.
Areas viewed as risky, such as Japan and Europe still retain an element of valuation discount that makes the risk worth taking.
Finally, owning some cash with a willingness to reinvest at lower prices appears prudent to us.