Against a backdrop of ongoing fears of downside risk, political uncertainty and lackluster economic statistics, higher risk assets such as equities and high yield debt have quietly delivered strong returns in 2012.
Of course, safe assets like government bonds have also continued to perform as rock-bottom interest rates underpinned the asset class. Could 2013 signal a more meaningful move out of safety into risk, out of quality into value? Are investors ready to shake off the pessimism caused by the Great Financial Crisis of 2008?
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The good news is that the political uncertainty that has weighed on market sentiment is gradually lifting. We think we are at ‘the end of the beginning’ of the European crisis.
Over the last two years investors have been seeking to gauge who was in charge, what their reaction functions were and what their willingness to backstop the system was. We are now at a point where we know we are in the hands of the Germans and the European Central Bank (ECB), that the Germans want deeper union and, based on Mario Draghi’s comments, that the ECB is willing to step in as required.
We may not like Germany’s pro-austerity stance and the ECB ‘put’ may be at a strike which is lower than we would like, but some of the extreme political risk is reduced and the situation is now uncertain rather than inscrutable.
Elsewhere, the Chinese political transition has occurred as planned and the new U.S. government has been chosen. Inevitably we’re still hostage to political brinkmanship in an environment where fiscal policy is so important, but market participants have begun to better understand political risk.
Stuck in a Loop
The bad news is that the cyclical environment is still challenging. In the normal way of things, one catalyst for a sustained turnaround in riskier assets would be signs of a turn in the economic cycle. The problem on this front is that we expect more of the same in 2013 – low interest rates and anemic growth. In this environment a strategy which favors higher quality stocks and is focused on enhancing yield through asset classes like high yield debt should continue to pay off, but the absence of a convincing, robust recovery will continue to weigh on more cyclical assets.
In the absence of cyclical triggers to ‘refresh’ our portfolio, we are using valuation as our primary guide and in this regard the environment is getting a lot more interesting. Firstly, safety is clearly looking expensive. With negative real yields on cash and bonds, we are increasingly incentivized to take more risk.
Endless quantitative easing makes cash our least favored asset class, we would argue that bonds only merit inclusion in portfolios due to their diversifying characteristics and we increased our allocations to equities in 2012. In fact, even based on conservative valuation assumptions, such as cyclically adjusted price to earnings ratios, equities look attractive.
Within equities, our ‘core’ exposure continues to emphasize quality but we have started to tactically take advantage of pockets of extreme value. For example we bought European equities in June, and Japan as we moved into the autumn. It is interesting to note that the value opportunities reside in the developed markets rather than the emerging markets.
According to the Chinese horoscope, 2013 is the year of the snake. If anything, I think that what many investors currently perceive as ‘safe haven’ assets could turn out to be the snake lurking in the grass next year.
Johanna Kyrklund is head of multi-asset investments at Schroders.
The views and opinions contained herein are those of Johanna Kyrklund, head of multi-asset investments, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.