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Shifting sands

The investment concept of taking risk when the central bank is on your side and avoiding it when it’s not – “Don’t fight the Fed” – may be a cliché but that doesn’t mean it's not good advice.

Old Mutual Global InvestorsThe investment concept of taking risk when the central bank is on your side and avoiding it when it’s not – “Don’t fight the Fed” – may be a cliché but that doesn’t mean it's not good advice.

History shows that monetary policy stimulus is usually good for riskier assets (typically equities), while policy contraction ultimately tends to put a cap on equity returns. Yet, the investing world of today is very different from pre – Lehman days when worldwide central banks’ monetary policy tended to move in sync. Today, monetary policy is desynchronised. While quantitative easing programmes in the US and UK have ended, Japan is more or less in the middle of its monetary stimulus, while Europe’s and China’s versions are just about getting underway. So, given the differing stimulus ‘cycles’ in which we find ourselves, and mindful of the fact that some authorities will soon be raising interest rates, whilst others loosening, how should we position portfolios?

We know from previous cycles that the first few interest rate hikes didn’t bother equity markets, primarily because the economy was in early cycle mode and interest rate increases were typically seen as a vote of confidence by central bankers over the health of the recovery. This time, there is something genuinely different. Looking at equity market valuations which, although not extortionately expensive, are not stand-out cheap and taking into account the US dollar rally, it is hard to do anything other than conclude that the “cat is out of the bag” in terms of US economic growth. Quite simply, the US growth picture should not be a surprise.

In the UK, the effect of weaker oil prices will have worked its way through the inflation numbers by the end of the year. As European growth also looks set to improve, Governor Carney may run out of excuses not to raise rates in early 2016. The hawks are beginning to circle, with average earnings growing well ahead of the pace of inflation, the labour market tightening and almost all measures of economic growth looking robust. Rationally, it’s hard to distinguish the UK from the US in these respects, although valuations in the UK do look more reasonable.

Japan looks set to remain in quantitative easing (QE) mode but valuations look increasingly dependent on the prospects for structural reform of both its economy and its corporate governance. Labour markets need to be much more flexible and corporate executives must focus on shareholder profits not stakeholder benefits. In practice, there’s precious little evidence of it actually happening yet. If the market starts to feel let down in these respects then this might easily become more important than monetary policy effects. For this reason we believe Japanese equities should be avoided.

Much more obvious is Europe where growth looks reasonable and policy has recently become very loose with a bigger than expected QE programme, negative rates and a weak euro to boot. All of these things are supportive for European risk assets and there’s absolutely no suggestion that these tailwinds are likely to change any time soon. European interest rates are likely to stay low for a long time. We feel the environment is right to buy European equities on bad days.

When interest rates begin to rise, investors should avoid the relevant government bond markets – that much is perhaps obvious. Higher yields equal lower prices which mean negative returns for bond investors, particularly when there is only a minimum yield cushion. As interest rates rise, we would also expect utilities, tobacco and healthcare companies, typical bond ‘proxies’, to fare badly.

Falling interest rates and ongoing QE have meant that the quality, utility like companies have been all the rage for almost ten years. We may be entering a new paradigm… or perhaps more like an old paradigm that we haven’t seen for a while, a bit like how ’70s “retro” clothing makes an occasional comeback. In a presentation I gave recently, I asked this question: “Is there anyone left alive who has lost money in bonds?” and I am now compelled to ask a similar question: “Is there anyone left in our industry who doesn’t hate cyclicality?” Will the managers who have been successful in recent years continue to be as successful as the dynamic shifts within the equity market from stability and towards volatility? Time to buy cyclicals?

On a final note, I hate holding cash in portfolios. People pay me to invest their money; they don’t pay me to sit on cash for meaningful periods of time. Yet, cash in portfolios does have some value. First, it gives you the option to buy things at a cheaper price in the future. Looking back to my earlier point, if US rate rises took the shine off their equity market for a while then other things being equal that’s probably a great buying opportunity. You would have to ask yourself why interest rates were going up, the answer being because the economy is healthy. It wouldn’t make sense for equities to stay weak under these circumstances.

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The views expressed by external contributors are not necessarily those of Old Mutual Wealth or Old Mutual International.

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