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Tactical Asset Allocations changes – October 2018

Tactical Asset Allocation Changes

UK market performance drives move to overweight in UK equities

In May we moved back to neutral in UK Equities and we have taken advantage of the recent market volatility to go overweight. The UK stock market is relatively cheap on a p/e basis compared to other world markets, trading at a price 12.5 times company earnings compared to the p/e of 16.7 of the United States. This is an opportunity to buy UK funds investing in world class companies such as BP, Glaxo and BHP Billiton at a reasonable valuation.

Although Brexit and its possible effects on the UK are all over the news, it is important to remember that much of the UK market is not tied to the fortunes of the domestic economy. The FTSE-100 is more of an investment in international growth with approximately 80% of its companies’ revenues coming from outside the UK.  Whether we have a hard or soft Brexit, it should have a limited fundamental impact on these international trading companies. For those companies that are more domestically orientated, much of the negative Brexit sentiment is already factored into their price.

Possible rate rises see a move to double underweight in corporate bonds

We have reduced further our weighting to Corporate Bonds. In the aftermath of the financial crisis ten years ago and QE moving interest rates to record lows, many companies took advantage to increase their borrowings by issuing bonds. Combined with central banks buying bonds as part of the QE strategy, the difference in yield between corporate and safer government bonds, (the yield spread), fell to record lows. Given that rates are now more likely to rise rather than fall, companies with high borrowings may find it tougher to make a profit in a new economic climate. This extra risk should be reflected in a widening of the yield spread. As yields rise, the value of bonds falls. At current levels we do not think corporate bonds’ yield spread over gilts is sufficiently wide to reflect the full extent of potential risks.

Asset allocation in detail

Asset Class – – = + ++ Comments
Managed Liquidity Neutral: The capital protection afforded by cash and interest bearing securities has been seen through the market volatility of recent months. Also, with the general upward direction of interest rates, it is reasonable to anticipate a rising yield from this asset class.
Government Bonds Overweight: Given the uncertainties of Brexit, and its possible effects on bonds, we prefer the defensive qualities of UK Gilts over other interest rate securities.
Index Linked Government Bonds Underweight: The UK Index Linked bond market has a duration of 22 years, driven higher over recent years by demand from pension funds. The asset class is therefore particularly exposed to a rise in UK interest rates, anticipated in 2019.
Corporate Bonds Double Underweight: In the era of QE since the financial crisis ten years ago, companies were able to issue bonds at historically low interest rates. Such was the demand for yield that spreads over safer government bonds reduced considerably. With interest rates on the way up, and perhaps with tougher times ahead, those credit spreads may widen to reflect increasing risk. This scenario would see the relative value of corporate bonds fall.
Global and Strategic Bonds Neutral: Yields looking increasingly attractive, however if the US Federal Reserve increases rates ahead of market expectations capital values are under threat. The rise in yields is predominantly on the assumption of normalisation of interest rates rather than on a fear of inflation. Yields would have to rise materially if inflation took hold.
UK Commercial Property Neutral: We expect capital appreciation to be muted over the next few years with the rental yield providing the majority of returns from property. Given there may also be difficulty with Brexit, a neutral weighting has been adopted.
UK Equity Overweight: The UK stands at an attractive valuation compared to other equity markets with clear opportunity to leverage its Oil and Gas exposure, as energy prices have firmed. The international diversity of the UK equity market acts as a hedge against Brexit, although the direction of Sterling is hard to call.
US Equity Neutral: The US corporate sector is still buoyant and earnings this year will benefit from tax cuts. As interest rates rise, there will undoubtedly be periods of volatility, but a significant bear market is unlikely given limited risks of a recession. Regardless of political events around the world, it is difficult to conceive of the dollar not remaining the pre-eminent safe haven currency.
Europe ex-UK Equity Neutral: Recent macro-economic data suggest a slowdown in the level of growth in Europe. Political issues in Germany and Italy have taken a more serious turn which is likely to be a drag on the economy and dampen investor sentiment.
Japan Equity Neutral: Japan is vulnerable to rising oil prices and trade wars, with major demographic challenges. However, there is now more political certainly and a clearer future for the reflationary policies of ‘Abenomics’.
Asia ex-Japan Equity Underweight: The threat of steadily rising US interest rates could pose a problem for this region which has issued high levels of US dollar debt. China’s relationship with the US is highly strained at present.
Emerging Market Equity Overweight: EM valuations still remain attractive and provided US interest rates, and the US dollar, are rising on the back of positive global economic growth, which will drive demand for EM exports, this asset class can still perform strongly. Selectivity in EM is key. Manager experience and skill is as important as ever.

Find out more about our asset allocation changes in our upcoming Quarterly Insight Webinar


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