In the first half of 2018, so far, we have seen volatility return to markets, a breach of the much anticipated 3% handle for 10 year US Treasuries, and an agreed summit between North and South Korea. As we continue to tread later into this cycle, investors seeking a consistent long-term real return need to balance the search for returns with capital preservation.
Five months into 2018, major equity markets are at levels seen at the very beginning of the year, although relative to recent years, it has been a wild ride. US equity indices may be at similar levels, but earnings have somewhat improved over this period, due to the stronger than expected earnings reported in the first quarter of 2018. This has to be measured against higher discount rates and an increase in volatility.
In this environment the risk allocation conundrum remains, particularly as there is an increasing acceptance that we are at a multi-decade inflection point in long term yields. Changes in regimes, such as this, will add to volatility (and opportunities) and likely play a greater role in influencing investors’ asset allocation decisions.
In this semi-annual note, we provide an update on our most recent review, in a period which continues to point to the need to be flexible and dynamic to achieve a real return.
Expected returns are slightly higher; so is volatility
The first five months have seen a number of episodes where volatility has jumped; first it was the selling of volatility and VIX-related products1; then the Libor-OIS2 scare; next was emerging markets (Korea, Argentina, and Turkey), and finally we have had Italy and trade wars. As mentioned in our last review, with valuations looking relatively expensive across a number of asset classes – financial markets are stretched and prone to volatility jumps. However, US tax cuts and quarterly corporate earnings have
provided a much needed boost to support valuations. That should give rise to some optimism, although with the money used mainly to increase share buybacks and pay-outs, rather than more investments, it is likely a one-off. Outside of the US, Brexit negotiations are moving at a snail pace, credit continues to build-up in China, and the on-going threat of protectionists’ strategies are keeping a lid on growth. The world is still global, and if we are looking at a slowdown in trade this will likely feed into earnings. A proxy for world trade is Korean exports, which have a close relationship with earnings growth, and has been flattening as demonstrated in Figure 1.
1 VIX is a volatility index created by the Chicago Board Options Exchange (CBOE) which shows the market’s expectation of 30-day volatility.
2 Libor Overnight Indexed Swap.
Figure 1: Global trade and equities earnings May 2002 to May 2018
Source: Bloomberg, First State Investments as at June 4, 2018
Overlaying the complexity of geopolitics between the two Koreas and a new world of diplomacy by twitter, it is easy to rationalise retreating from markets completely. Our role is to take all of this into consideration, but also look through the headlines to determine the opportunities to rebalance region by region and asset by asset.
The first step in our investment process is to decide on the outlook for the economy. This involves deciding on where we think the global economy is moving and then for each country, we determine the likely long-term values for inflation, risk free rates, long-term bond yields, and earnings growth. By taking current valuations as a starting point, this allows us to determine expected returns for global assets from this point forward.3
As an example, for the UK the following views were taken into consideration (we do this for all regions):
- Inflation has come down somewhat, although is still elevated at 3.4% and running above the US and Europe. Sterling has been flat over the last year in trade-weighted terms but has not recovered from 2015 levels. As a trading nation, Brexit poses risk to the upside for inflation if new trade deals are not in place next year.
- We believe that the risk free rate will remain stable in the short term, as the Bank of England has pushed out its (in our opinion too aggressive) hiking cycle; this is a direct consequence of a slowdown in growth.
- Long-term bond yields in the UK are low, both in nominal and real terms. High demand from pension funds and a lack of supply can explain some of this, but the market is pricing low growth. We therefore think this makes the UK long-end unattractive for investors that are not forced to hold them for liability management purposes.
- Earnings growth expectations remain stable, with much of the large-cap space having significant earnings overseas.
We have seen expected returns fall across asset classes for years with bull markets in equities, government bonds and credit. While equity markets are not far from where they started the year, solid earnings means expected returns are a little higher than in our last review. The same is the case for government bonds and credit; but they are still low for investors seeking real returns of four percent a year – the historical equity return over the last hundred years in the UK and the US.
As asset allocators, we look at where we believe to be attractive opportunities. We have a broad investment universe allowing us to choose the asset classes, regions, and sectors that in our view offer the best risk-adjusted returns.
3 For a more in-depth review of how we determine expected returns, please see our research paper on the topic.
Outlook for equities
Equity valuations in most major developed market countries remain high, with the US the most expensive, on a forward looking basis. On a relative basis, UK and European equities are flat this year but with better earnings, lowering the forward price-to-earnings ratio from late last year. European growth has been softer in 2018 following strong data last year. A stronger Euro hampered export growth and lower confidence surveys points to lower household spending. Europe has expanded for 19 consecutive quarters and prospects for earnings growth remain healthy, as such we still see selective value in European equities – despite political turmoil.
While volatility has increased in emerging markets (“EM”), current levels do offer a chance to increase exposures. Historically EM have been exposed to a weaker US dollar, but over time EM economies have been able to borrow in their local currencies and move away from hard currency borrowing, which we believe lowers their vulnerability relative to previous crisis in those regions.
Outlook for credit
Fundamental drivers of fixed income markets in 2018 suggest that yields should continue to rise, particularly if inflation increases. High yield has not had a positive start to 2018, with spreads vs. government bonds having increased in Europe while flat in the US (government bonds sold off, so the return is negative.) We do not hold any high yield exposure in the Fund after selling down this exposure in late 2017.
Figure 2: High yield spreads May 2013 to May 2018
Source: Bloomberg, First State Investments as at May 31, 2018. Option-adjusted spread vs. government bonds
Emerging market credit continues to offer relatively good risk-reward, with global trade increasing and commodity prices underpinning expansion and the higher yields offering a reasonable carry return to hold the higher volatility expected from these assets. We continue to allocate our duration exposure to EM bonds, both hard and local currency.
Outlook for government bonds
Developed market government bonds are breaking out of the multi-decade bull-run and we have started to see the much anticipated rise in both short and long term yields, as evidenced by the US 10-year breaking through the 3% level. The path to higher yields is expected to continue the trend higher after a period of consolidation following the recent volatility. Some inflation-linked bonds offer value and we continue to hold these in Australia and the US, with the risk of higher inflation than we have experienced in the last couple of years.
Figure 3: 10-year government bond yields June 1989 to May 2018
For global investors looking for a real return (i.e. a return over inflation), fixed income provides little direct help. Below we have charted a snapshot of real yields across developed and emerging markets (y-axis) and compared with their current account (x-axis).4 This demonstrates two things: one, that there are few places where high real yield is available without credit risks (countries like Brazil, Mexico, and Russia); and two, countries that have to borrow because they save less than they invest have to pay a higher interest rate, and are often more economically vulnerable to shocks. As global investors this allows us to invest in countries where the return looks attractive on a relative basis.
4 The current account equals savings minus investments for each country. A positive current account balance means that the country has to borrow abroad (yes, we are simplifying).
Note: The 10-year on-the-run linker used (or closest possible).
Source: Bloomberg, First State Investments as at May 31, 2018
Within our investment process we have two building blocks. The first, which we call Neutral Asset Allocation (NAA), sets longer-term asset allocations. The second part, which we call Dynamic Asset Allocation (DAA), allows us to exploit shorter‑term opportunities in markets.
The first step of our NAA process is to set the economic climate for each country. We use the economic climate assumptions within our set of proprietary stochastic simulation models to determine forward looking risk premia and expected returns. The process of determining the NAA uses these expected returns for the building blocks of the portfolio allocations incorporating the return objectives, constraints, and investment horizon of the portfolio.
Our DAA process, on the other hand, takes into account the shorter-term market dynamics to deliver additional returns and abate portfolio risks, such as tail events. This part of our investment process, which includes our investment signals and qualitative overlay, is formally reviewed each week and looks at (among other things) markets and fundamental data to take advantage of possible dislocations.
Our Neutral Asset Allocation as at May 2018
As a consequence of our outlook for the global economy and the current valuation levels, we have made a number of changes to our Neutral Asset Allocation (“NAA”). Most notably we have increased exposures to global equities, while maintaining no exposure in corporate credit. Our allocation to global government bonds is mainly allocated to developed market inflation-linked bonds, while we have reduced our holdings to hard currency emerging market debt. Finally, we have maintained the allocation to Commodities, which was introduced in the last review.
Source: First State Investments
The increased exposure to equities allows us to benefit should strong earnings continue, while the reduction in emerging market credit (and maintaining no exposure to corporate credit) allows us to maintain the right risk allocation for the Fund.
The NAA is only the first step in setting our overall portfolio allocation. To ensure that we maximise the probability of reaching our five-year real return objective, we use our Dynamic Asset Allocation (“DAA”) to add alpha to the Fund, when long-only exposures are not enough to generate sufficient return. In other words, our NAA is the ‘beta’ in the portfolio, while the DAA is the ‘alpha’.
How do we determine the right mix of NAA (beta) and DAA (alpha)?
Based on our assumptions for the economic climate, and our expected returns, we can determine the likelihood of meeting the portfolio’s investment objective over the investment horizon. It is becoming increasingly likely that relying solely on the NAA in a constrained long-only, unlevered environment will not be sufficient to meet the return objectives. This is where we use our DAA process to take into account shorter-term market dynamics to deliver additional returns and abate portfolio risks, such as tail events. By adding an uncorrelated return source (alpha) we can improve the portfolio’s likelihood of meeting the investment objective.
The combination of NAA and DAA requires the consideration of the current allocations; as the extent to which active management may be used is managed through the portfolio’s risk budget to avoid unwanted additional risks. We consider both the tracking error (as well as other risk metrics) and the expected return, in assessing the portfolio’s ability to meet its investment objective.
The ability to add scalable alpha to portfolios provides flexibility to deliver on the investment objective; even in a lower return environment. We incorporate this analytically and Figure 6 illustrates the impact that both tracking error and alpha can have on the risk and return characteristics of the portfolios on the efficient frontier.
The investment objective of the Fund is UK Retail Price Inflation +4% gross of fees over a rolling five year period. The NAA strategy, shown in the following chart provides a nominal return of just under 3%, leaving a shortfall in required returns to meet the Fund’s objective. Based on this NAA and the required return for the Fund, we have maintained the DAA tracking error risk budget at 6% to maximise the potential of us of reaching our investment objective, as outlined below.
Source: First State Investments
Therefore, even in a lower return environment, by allowing the blending of alpha and beta strategies to be more dynamic within the framework described above, we still have the potential to deliver on our client’s investment objectives.
In the current low return environment it is critical to have the flexibility to blend beta and alpha to deliver a real return of 4% for the Fund over five years. Our investment process and philosophy provides our clients the highest possibility of obtaining a real return, with the current outlook making our DAA paramount.
These figures refer to the past. Past performance is not a reliable indicator of future results. For investors based in countries with currencies other than the share class currency, the return may increase or decrease as a result of currency fluctuations. Performance figures have been calculated since the launch date. Performance data is calculated on a net basis by deducting fees incurred at fund level (e.g. the management and administration fee) and other costs charged to the fund (e.g. transaction and custody costs), save that it does not take account of initial charges or switching fees (if any). Income reinvested is included on a net of tax basis. Source: Lipper IM / First State Investments (UK) Limited.
Why First State?
Our investment strategy blends the qualitative views and experience of the team with the discipline and rigor of quantitative analysis resulting in a flexible approach to design and implementation of investment portfolios.
Investment decisions are taken with respect to the overall portfolio objective, unconstrained by conventional benchmarks or fixed asset allocation. Our flexibility to blend alpha and beta strategies is a key differentiator and essential to deliver on the investment objective over time.
Risk management is integral to our investment process. We continually seek to balance the trade-off between upside potential (meeting our investment objectives) and downside risk (capital loss), which we believe can generate consistent results.
This document has been prepared for informational purposes only and is only intended to provide a summary of the subject matter covered and does not purport to be comprehensive. The views expressed are the views of the writer at the time of issue and may change over time. It does not constitute investment advice and/or a recommendation and should not be used as the basis of any investment decision. This document is not an offer document and does not constitute an offer or invitation or investment recommendation to distribute or purchase securities, shares, units or other interests or to enter into an investment agreement. No person should rely on the content and/or act on the basis of any material contained in this document.
This document is confidential and must not be copied, reproduced, circulated or transmitted, in whole or in part, and in any form or by any means without our prior written consent. The information contained within this document has been obtained from sources that we believe to be reliable and accurate at the time of issue but no representation or warranty, express or implied, is made as to the fairness, accuracy, or completeness of the information. We do not accept any liability whatsoever for any loss arising directly or indirectly from any use of this information.
References to “we” or “us” are references to First State Investments.
In the UK, issued by First State Investments (UK) Limited which is authorised and regulated by the Financial Conduct Authority (registration number 143359). Registered office Finsbury Circus House, 15 Finsbury Circus, London, EC2M 7EB number 2294743. Outside the UK within the EEA, this document is issued by First State Investments International Limited which is authorised and regulated in the UK by the Financial Conduct Authority (registered number 122512). Registered office: 23 St. Andrew Square, Edinburgh, EH2 1BB number SCO79063.
Certain funds referred to in this document are identified as sub-funds of First State Investments ICVC, an open ended investment company registered in England and Wales (“OEIC”). Further information is contained in the Prospectus and Key Investor Information Documents of the OEIC which are available free of charge by writing to: Client Services, First State Investments (UK) Limited, Finsbury Circus House, Finsbury Circus, London, EC2M 7EB or by telephoning 0800 587 4141 between 9am and 5pm Monday to Friday or by visiting www.firststateinvestments.com. Telephone calls may be recorded. The distribution or purchase of shares in the funds, or entering into an investment agreement with First State Investments may be restricted in certain jurisdictions.
Representative and Paying Agent in Switzerland: The representative and paying agent in Switzerland is BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich, Switzerland. Place where the relevant documentation may be obtained: The prospectus, key investor information documents (KIIDs), the instrument of incorporation as well as the annual and semi-annual reports may be obtained free of charge from the representative in Switzerland.
First State Investments (UK) Limited and First State Investments International Limited are part of Colonial First State Asset Management (“CFSGAM”) which is the consolidated asset management division of the Commonwealth Bank of Australia ABN 48 123 123 124. CFSGAM includes a number of entities in different jurisdictions, operating in Australia as CFSGAM and as First State Investments elsewhere. The Commonwealth Bank of Australia (“Bank”) and its subsidiaries do not guarantee the performance of any investment or entity referred to in this document or the repayment of capital. Any investments referred to are not deposits or other liabilities of the Bank or its subsidiaries, and are subject to investment risk including loss of income and capital invested.