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Asset Allocator

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No hiding place from tech's troubles; Come with me to a world of pure correlation

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America last?

Those investors who have been constructing their portfolios on the basis that the US market was expensive and likely to underperform its peers will have found this to be an expensive trade over the past decade.

But 2022 has started with a fresh bout of a rotation away from big tech stocks as investors start to examine more neglected equity areas due to higher interest rates becoming a more realistic prospect. This is making the ‘America last’ trade a more compelling proposition for many. 

Analysts at Research Affiliates believe the US’s underperformance could last for longer than just the recent interest rate cycle. 

They forecast the expected annualised nominal return from UK equities to be 8.5 per cent per annum for the next decade, with emerging market equities delivering an annualised 9.4 per cent return. But they are expecting a meagre 1.9 per cent annualised from US large cap equities. 

Given that Research Affiliates takes pride in being a value investor, it’s probably no surprise its models favour traditional value plays. Its research models different discount rates against the CAPE valuations of each market over a decade, and seeks to identify which markets are overvalued.

Its estimate is that equities generally will struggle to replicate the gains of the recent past, primarily because of valuation contraction, with growth in earnings being in the range of 1.4 per cent, and dividends at about 2 per cent globally. 

Research Affiliates’s view is that equity returns cannot exceed the returns generated in the real economy indefinitely, so the slower rate of growth for future earnings will negatively impact on equity valuations.

And since the US is the market where valuations are pricing in the most optimism for the future, it is likely to be the market which will underperform most, particularly when compared with those whose valuations reflect a more cautious worldview. This cautious outlook hasn’t stopped Alan Miller of discretionary house SCM from shifting assets away from bonds and into equities, though he has been deploying the extra capital into the UK and emerging markets in anticipation of a prolonged rotation. 

Correlation condunrum

Although the US market has become synonymous with the group of big tech stocks once called the FAANGs (though Facebook’s rebrand to Meta and Google’s rebrand to Alphabet has made this acronym a little less neat) there is of course a vast array of businesses listed in the US drawing revenues from all sorts of areas of economic endeavour. 

But investors switching into these stocks to escape a monetary policy-driven sell-off in big tech could be disappointed, according to Melissa Brown, managing director of research at risk analytics and index provider Qontigo. 

She says the volatility of the US market as a whole has likely increased in recent months, with the knock-on effect being increased correlation within equity markets. 

Brown’s view is that tighter policy is likely to increase the level of correlation between US stocks, as investors broadly exit equities, and that will increase volatility as investors will be unable to buy different equities to position for different outcomes as they largely move in the same direction.

This may prompt investors to look overseas for diversification, causing the broad US equity market to decline, including many of the shares and funds that asset allocators may group as ‘value’ which ought to be immune from the current sell-off. 

This may also lead to increased correlation between the different equities in non-US markets as capital pours in, meaning geography should - in Brown’s view - take precedence over style during the coming period of volatility. 

She still expects the more typical ‘growth’ stocks to perform worse, but thinks US value will not prove to be a safe port in the storm.

Interest piqued?

Gerard Lyons, former chief economist at Standard Chartered and now a shareholder and chief economist at DFM Netwealth, has said December’s rate rise means UK inflation will peak at 6 per cent later this year, rather than 7 per cent if monetary policy hadn’t tightened. 

He feels the biggest concern investors should have at the moment is how central banks are communicating policy, more than the decisions themselves.

Lyons says markets responded positively to the US Federal Reserve’s decision to lift rates, as it indicated the central bank has inflation under control. He contrasted this with the Bank of England, which seemed to suggest interest rates would rise in November before failing to act, and then surprising markets in December when it actually did tighten policy. 

The upshot for asset allocators, says Lyons, is that investors may decide the UK’s central bank isn’t capable of controlling inflation - something which would be a negative for the domestic stock market relative to those, such as the US, where investors have more confidence in policy makers.

Asset Allocator is written by Dave Baxter and David Thorpe

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