Is it time to raise risk in portfolios?

After all, a more benign outlook for rate rises in 2023 has proved beneficial for bonds and shares; as a recent investment note from Axa Investment Managers states: "Markets are rallying because this period of monetary tightening is almost over.

"Not raising rates anymore is, by itself, bullish for stocks", says Chris Iggo, chairperson of the Axa IM Investment Institute.

But not everyone is keen to rush into risk assets.

Some managers advocate caution, while others suggest raising risk right now is itself too risky.

If you think inflation will be lower, then there is no doubt bonds are a more attractive investment now than they were last year.Mike Coop, Morningstar

One cautious commentator is Mike Coop, chief investment officer for EMEA at Morningstar.

He says the set of possible economic and market scenarios is “unusually wide” from here, and so increasing exposure to risk assets is unwise.

Coop believes that portfolios should always have investments which do well in a wide range of scenarios, “rather than trying to predict when a recession will happen, which is impossible, and then position for that recession, one should always be thinking about recession protection.

"One should always be thinking about inflation protection, and having assets that perform well in both of those scenarios in portfolios.”

He says returns were stronger than the market average for his portfolios in 2022 as a consequence of being very underweight US equities and bonds, and owning more in the UK. 

Of the rationale for those decisions, he says: “We worked with our equity research team on the prospects for the tech companies in particular in the US, and felt that even on an optimistic view, they were overpriced.

"And as far back as 2020, when the marketing was sharply pricing in a recession and no one was worried about inflation, we were able to buy energy stocks very cheaply, and those offered inflation protection last year."

Valuation is key

He adds investors tend to forget about inflation protection when recession font and centre, and forget about recession protection when inflation is front and centre. But the key is always to think about valuation.

"An asset could do well if there is a recession, for example, but still be a poor investment if priced wrongly", Coop says, adding: "US equities continue to be overpriced, and equities generally are not cheap".

As for bonds, he feels bonds are more attractive right now, despite being a slightly "less intuitive" investment in a world of higher inflation.

He says: “If you want to own a bond for the medium to long-term, say 5-15 years, then really the rate of inflation today is less important than what the rate could be over the average lifetime of the bond.

"So I get that people look at the inflation rate today and the bond yield on a government bond today and see its negative in real terms, especially if you think inflation is going to average the current 10 per cent level for the duration of the time you own the bond.

"But if you think inflation will be lower, then there is no doubt bonds are a more attractive investment now than they were last year, because the nominal yields are higher than they were last year.

"The best way to think about government bonds is as a form of insurance against equities doing badly. And the yield you get is like the insurance premium.”

But he is less keen on the investment case for high yield bonds right now, having bought into the asset class in 2022, as he feels prices have risen too much. 

Coop says that while markets are starting to price in a scenario whereby inflation and interest rates have peaked, he is more cautious, taking the view that the re-opening of China could very possibly lead to an increase in inflation on the demand side.

He adds: "Changes in the Ukraine/Russia conflict could have a major impact on energy and commodity prices, so for that reason, I don’t think now is the time to be adding risk to portfolios.” 

Mood music

Rupert Thompson, chief economist at Kingswood, is also cautious, but thinks there could be a more firm recovery later on in 2023.

He says there has been a change in the mood music from policy makers in 2023, with indications they feel a brighter outlook for the global economy will happen, principally as a result of the re-opening of the Chinese economy. 

He says the renewed optimism is also a function of the mild winter keeping gas prices lower in Europe than might otherwise have been the case, something which he says has boosted business confidence in the economic bloc. 

According to Thompson: “We still believe that markets could well retreat again over coming months before staging a more firmly based recovery in the spring or summer.

"There are two main reasons for our caution: the first is the market’s confidence that the Fed will be cutting rates in the second half of the year despite its protestations to the contrary; the second is the continuing downside risk to corporate earnings which markets seem to be ignoring.”

Data from consultancy firm ARC indicates that discretionary fund managers have generally been moving away from cautious portfolios-they account for just one per cent of the capital deployed in the portfolios covered by ARC, while the typical balanced portfolio, the most widely owned by those investors ARC work with, rose 3.5 per cent in January. 

Graeme Harrison, chairman of ARC, says the low levels of allocation to cautious mandates may be a legacy of the decade when equities generally rose.

Harrison expects 2023 to be a year in which the allocations to cautious portfolios increases, as a function of investors mindset changing due to the volatility of the past year. 

Continued caution

David Jane, multi-asset investor at Premier Miton, is another investor who is cautious about the outlook for 2023, partly because he expects inflation to linger at higher levels than many market participants currently expect. 

He feels this could mean gold performs well in 2023, and also expects different types of equities could do well.

Jane says: “While the consumer sector is especially important for the US economy, last year earnings growth at the energy companies was a major driver of overall profit growth.

"With oil prices flat to down, profit growth here is not likely to be as strong. However, other sectors may take up the running. Base metals prices have been strong and demand is picking up because of China reopening and energy infrastructure investment."

According to Jane, industrials have also recently been performing strongly, partly on the reshoring and deglobalisation argument. While these factors are unlikely to be impacting current profitability, he feels cost pressures may also be an issue.

Jane adds: "Outside the US, in Europe and Japan, we would expect to see early indications of any economic slowdown. These economies are generally seen as more sensitive to economic condition than the more resilient and consumer focused US.”

So while there is reason for cautious optimism, and an expectation that riskier assets might come into their own later on down the line, the general feeling is to hold off ramping up the risk in portfolios.

David.thorpe@ft.com