2017 has been a very good year for equity and credit markets.

2017 has been a very good year for equity and credit markets. It comes in the tenth year of the current bull market, with phrases like “grab for yield” and “low volatility for longer” being chanted more frequently by investors. In this environment, what is the prudent thing for investors seeking a consistent long-term real return to do - keep buying assets that look increasingly expensive, or leave something on the table as prices keep going up, thus potentially missing out on further gains? In short, as markets continue to rise and rise, the asset allocation conundrum has become even harder.

In this semi-annual note, we discuss how we approach the asset allocation challenge in a world where valuations look increasingly stretched, demonstrating why we believe it is ever more important to be flexible and dynamic to achieve a real return.

 

Expected returns – where to from here?

2017 has seen an impressive run for risk assets, with equities and credit markets delivering solid returns. Markets have been pre-occupied with (potential) tax cuts in the US; Brexit in the UK; and continued credit build-up in China – all the while they have continued to rise. Markets have weathered the volatile political landscape of the last few years well, but looking ahead we see potential headwinds – with stretched valuations providing a difficult starting point to believe that the last few years will be a good guide to the next.

The first step in our investment process is to determine our outlook for the global economy. We determine the likely long-term values for inflation, risk free rates, long-term bond yields and earnings growth for each country. By taking current valuations as a starting point, this allows us to determine expected returns for global assets from this point forward.¹

To give an example, for the UK the following views were taken into consideration:

- Inflation has been rising for a while, with the weaker currency feeding through to prices and eroding real wage gains. With the structural changes to the economy stemming from the Brexit negotiations, we still see relatively high inflation working its way through the economy.²

- Risk free rate should remain low, both in real and nominal terms. While the Bank of England recently hiked rates for the first time in ten years, the likely weakness in the economy means we do not foresee sustainably higher rates.

- Long-term bond yields are expensive with nominal rates in particular looking unattractive at current levels. While there are structural reasons for UK gilt yields to remain subdued (low potential growth and a pension sector that has enormous demand for long-term duration), higher inflation means that real rates are currently extremely low.

- Earnings growth expectations are low, with productivity having been low since the Global Financial Crisis. Alongside the uncertainties from Brexit and likely lower investments and high household debt, this will naturally feed through into earnings, despite the support of easier monetary policy. This will, in particular, mean that earnings growth for more domestically oriented firms have a poorer outlook.

The theme of rising inflation extends to both Europe and the US, though while the UK has seen a rise in inflation largely a result of falling currency, we believe growth prospects look more robust in the US and Europe as wages keep up. We are therefore more positive on earnings growth in those regions, with Europe in particular looking stronger than it did a year ago.

Inflation is picking up

Source: Bloomberg, First State Investments as at 30 November 2017

Since Brexit Sterling has fallen nearly 20% against its main trading partners.

With a weaker currency feeding into higher inflation, real wages have been falling in unison with Sterling.

Sterling’s performance

Source: Bloomberg, First State Investments as at 30 November 2017

Note: October, 2015 = 100. Trade weighted is currency performance weighted by trading partner

Please remember that past performance is not a reliable indicator of future results.

If savers are to generate a real return on their capital, in an environment of higher inflation, interest rates appear unattractive as they are unlikely to keep up with the pace of inflation. We have illustrated this below, with two indicative measures of where the market expects inflation and UK interest rates to be for the next five years. In real terms, money in the bank is likely to be worth a lot less, especially in the near term, questioning one of the traditional asset classes that markets usually turn to park capital.

What a difference a benchmark makes

Source: Bloomberg, First State Investments as at 30 November 2017

Note: expected inflation calculated from inflation swaps. Expected Libor is calculated from Euro$ futures. Both are estimates.

These figures are estimates only and are for illustrative purposes. The results cannot be guaranteed.

Where does that leave us when determining expected returns for other asset classes? Most now appear unattractive, which is perhaps to be expected, following ten years of strong returns in equities and sustained yield compression occurring simultaneously. Notwithstanding this, there are still opportunities for prudent investors to generate real returns.

¹ For a more in-depth review of how we determine expected returns, please see our research paper on the topic.

² The Office for Budget Responsibility: Economic and Fiscal Outlook (November 2017).

Outlook for equities

Estimated 2018 forward P/E ratios

Source: Bloomberg as at 30 November 2017

Note: Forward P/E = Current price / next year’s estimated earnings (average of forecasts)

These figures are estimates only and are for illustrative purposes. The results cannot be guaranteed.

Equity valuations in most major developed markets are at elevated levels, with the US looking particularly expensive in our view. In 2017, investors have seen high equity returns, but also very low volatility. This can be seen both in realised and implied volatility, where markets are currently pricing for a continuation of this low volatility environment.

Implied volatility for equities and bonds

Source: Bloomberg, First State Investments as at 30 November 2017

Note: Bond vol is 1y10y swaptions volatility times duration of 10-year swap

Without a commensurate increase in earnings, we see less incentive to continue to hold equities. Despite this we do see pockets of potential value in Europe and emerging markets, notably Asia (China, Korea, Taiwan) and Latin-America (Brazil, Mexico).

European growth has been broad based, with consumption growth coming from higher wages and employment, and capital expenditures are rising again. Earnings growth appears healthy, and with the European market relatively cheap we see value in European equities. Whilst emerging markets valuations are less attractive after the rally of the last few years, global trade volumes are still expanding at a steady pace, benefitting emerging market equities by providing a catalyst for continued earnings growth.

Outlook for credit

Credit has performed strongly over the last few years, with US high yield spreads compressing from over 800bps in February 2016, to under 400bps as at November 2017. Valuations appear to be at the richer end of the spectrum and we do not foresee further catalysts to drive spreads any tighter. Given where we believe we are in the economic cycle (late stage expansion), we believe that US and European credit is not offering sufficient rewards for the risks.

Global credit spreads

Source: Bloomberg, First State Investments as at 30 November 2017

Note: Option adjusted spread over gov’t bonds for corporates; spread over US treasuries for sovereigns

Please remember that past performance is not a reliable indicator of future results.

Credit in emerging markets, on the other hand, offers relatively good risk-reward in our opinion, with global trade increasing and commodity prices underpinning expansion.

Outlook for government bonds

Developed market government bonds have been in a multi-decade bull-run, with rates now at levels that to us make them unattractive to hold to deliver real returns. We think some inflation-linked bonds offer value, and we continue to hold these, as do emerging markets in both hard and local currency.

10-year bond yields

Source: Bloomberg, First State Investments as at 30 November 2017

Please remember that past performance is not a reliable indicator of future results.

Investment process

Within our investment process we have two building blocks. The first, which we call Neutral Asset Allocation (NAA), sets longer-term asset allocations and is based on our view of economic fundamentals over the coming five years. 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 NAA as at end November 2017

As a consequence of our outlook for the global economy and the current valuation levels, we have made a number of changes to our NAA. Most notably, we have sold all of our exposure to high yield and reduced our exposure to longer-dated UK gilts. We have increased our equity allocation slightly to selective attractive markets. We have also increased our allocation to cash to be able to take advantage of opportunities should they arrive. Finally, we have added an allocation to commodities.

Source: First State Investments

These figures are estimates only and are for illustrative purposes. The results cannot be guaranteed.

Our NAA has exposures to markets we still think are attractive on a risk and reward basis and offer a good expected return for the level of risk over a five year period. With valuations where they are, we do not have to be invested in any asset class in our NAA, and moving the credit risk into equity and cash gives us the option of participating in the strong market while preserving capital if (when?) volatility picks up.

However, 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 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 aim 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 the chart below 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. The NAA strategy, shown in the following chart provides a nominal return of just over 2%, 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

Returns referred to are intended to provide only an example of the potential of the investment strategy to be employed and do not take into consideration actual trading conditions and transaction costs. The figures are for illustrative purposes only and results cannot be guaranteed.

In the current low return environment it is critical to have the flexibility to blend beta and alpha to aim to deliver a real return of 4% for the Fund over five years gross of fees. We believe our investment process and philosophy provides our clients the highest probability of obtaining a real return, with the current outlook making our DAA paramount.

* The maximum loss of a portfolio with a given probability, defined as the confidence level within a specific time frame. For example, if a portfolio has a 1-year VaR of 7.2% at the 95% confidence level, it is implied that, under normal trading conditions, the portfolio manager can be 95% confident that its portfolio will not decrease more than 7.2% in one year.

Performance overview

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 rigour 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.

Important Information

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.

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