Tactical Asset Allocation update: Q4 2021

Asset class

Q4 2021 Score

Direction of travel

Commentary

Overall

4

↓

Any hikes are expected to be gradual and we should remember that even a 0.5% increase in UK base rates would still mean we are effectively on emergency monetary policy. All the worry around higher UK rates also serves as a reminder that, while this dominates newsflow, we are running diversified portfolios on which the impact of hikes by the Bank of England should be limited.

We also continue to believe inflationary concerns will be temporary rather than long lasting. While headline figures are elevated at present, core levels remain fairly steady. On the former, we are seeing a kind of rolling base effect move through the system, with gas prices causing a spike one month and used cars the next, but none of these are likely to calcify into higher long-term core inflation.

We appreciate the direction of bond yields will be upward over time but, as ever, the path will not be linear and we maintain exposure to this asset class for its diversification to equities, some level of inflation insurance and increasing income.

Although aggressive tightening is not on the agenda, the world needs to get comfortable with a new status quo where crisis-level monetary policy is no longer essential. Following recent peaks in policy support, growth and markets, we would expect to see global GDP moderate to above-trend levels next year and more active stock selection will be required in such an environment, with the broad rally since last year's vaccine announcements thinning out.

Cash

1

↓

Cash offers little to no prospect of a real return in the coming years, with major central banks remaining committed to loose policy. Cash does have the benefit of offering a store of value at times of market stress, so a modest allocation may be appropriate depending on the mandate.

UK gilts

2

↑

Yields have risen off their extreme lows in recent months and we moved slightly less negative on gilts in Q2 2021. This asset class remains underwhelming overall, however, with the bias of risk continuing to be to the upside for yields (or to the downside in price terms), especially if higher inflation persists.

Gilts still provide a useful function as portfolio insurance in times of market duress but offer little more than a cushion to equities.

Global government bonds

2

↑

A global basket of currencies and interest rate risks can result in a differentiated return stream from UK gilts. Yields remain close to lows and the bias of risk looks to be to the upside (or the downside in price terms), especially if higher inflation persists.

We would suggest any forthcoming policy tightening is already in the price and Jay Powell's re-appointment as Federal Reserve chair brings a sense of consistency into next year. These bonds still provide a useful function as portfolio insurance in times of market duress but offer little more than a cushion to equities.

Investment grade (IG) corporate bonds

3

↑

We increased our rating on investment grade credit from two to three in Q3 2021, in recognition that spreads versus government bonds offer a reasonable yield pick-up while providing strong credit quality.

We feel that with markets having come a long way from Covid-inspired lows, a moderate shift from high yield to IG indicates a sensible risk re-allocation across our funds and portfolios. In times of market stress, this debt should also benefit from its inherent duration.

Index-linked bonds

3

↑

This debt would benefit versus nominal government bonds if inflation continues to run ahead of expectations, although the possibility of higher prices is now more widely anticipated than it was last year. Index-linked bonds tend to have longer duration than the same tenor nominals so duration positioning needs to be considered. Big moves out in yields will also impact these bonds. It is best to buy inflation protection when the risk is underappreciated, which is not the case today.

High yield (HY)

3

↓

While still overweight high yield, as the overall risk-on environment should be supportive of prices, we believe moves in spreads have made these bonds relatively less rewarding for their level of credit risk and moved our rating down from four to three in Q3.

Emerging market debt (EMD)

3

↑

Spreads look reasonable but the idiosyncrasies of the emerging market environment are potentially better rewarded in EM equities. Furthermore, US dollar- denominated debt will be subject to moves in the US yield curve. There is some potential for support from a softer US dollar, better liquidity than expected, and carry hunters.

Convertibles

3

↓

We continue to see convertibles as providing an attractive risk/return profile thanks to their optionality and bond floor. Our view has moved down from four to three aswe are taking profits after a strong spell of performance and feel the asset class has potentially peaked for this cycle.

Equities overall

4

↓

The risk-on environment continues to favour equities. Markets have come a long way from the 2020 lows but this is largely justified by government spending and decent corporate results.

Across our funds and portfolios, we continue to be bullish on the reflation trade and are positioning for three long-term views: global ex-US equities are more attractive than the expensive US, small caps should outperform large, and value should outstrip growth, all of which run contrary to what happened for most of the 2010s.

More hawkish central banks have driven a rotation back into the value end of the market, after a pause over summer, and we feel many of these companies remain very cheap.

We currently favour Europe and the UK, with slightly lower conviction on Japan.

US equity

3

↑

Valuations look elevated for the index overall, although the picture is better outside of mega-cap growth. A shift back towards 'real world' rather than virtual interaction will put pressure on technology revenues and, overall, share prices have discounted better-than-expected earnings.

US small caps

4

↑

Despite our overall caution on the US, we see smaller companies as ripe for a rebound in light of their significant underperformance versus large caps. As the recovery broadens, investors will be looking elsewhere and consumers flush with cash should benefit domestically orientated companies, especially small caps.

As the economy reopens (we are bullish about the cycle), small caps should outperform large. A risk to this would come from tax hikes, which tend to hit small and mid-cap companies more than their larger counterparts.

UK equity

4

↑

The UK was hit from all sides in 2020 with Covid impact, sector composition (heavy in struggling resources, financials and energy), and Brexit combining to make it the most unloved major market. Despite its global revenue base, there is too much pessimism in the price so, tactically, this is an attractive market. A strong pound is likely to be a headwind, however.

UK small caps

4

↑

A strong rebound in UK smaller companies is already under way but there is further scope for mean reversion with Brexit uncertainty disappearing, sterling normalisation and further merger and acquisition (M&A) activity. Enhanced economic activity thanks to vaccine rollout should also provide impetus to domestic-orientated names.

European equity

4

↓

Europe's vaccination effort continues to improve and the region has been a major beneficiary of a global recovery and normalisation. Export-led European stocks are geared into a global recovery and consumer brands should benefit from high levels of spending power turning on post lockdown. Overall, valuations look attractive and Europe is further along the environmental, social and governance (ESG) path on a company by company basis than other markets.

European small Caps

4

↑

European small caps are under similar pressures to their larger counterparts but should be well positioned to take advantage of global reopening and increased domestic consumption on the continent. Prospects would come under pressure should governments accelerate their plans to balance the books.

Japanese equity

3

↓

Our conviction on Japan has fallen (from four to three) and for now, we prefer to spend our equity risk in areas such as Europe and the UK. That said, the country has made great strides in its vaccination effort and recent political upheaval looks to be resolved with new prime minister Fumio Kishida in place.

Japanese small Caps

3

↓

Japanese small caps are under similar pressures to their large counterparts but should be well positioned to take advantage of global reopening and increased domestic consumption.

Emerging markets equity

4

↓

Emerging markets will benefit from the global reflation trade, with loose monetary policies and a weak US dollar also providing a supportive environment. Long-term fundamentals remain intact but shorter-term pandemic shocks, with generally slower vaccination rates, and recent policy shifts in China, as the state aggressively reins back certain sectors, continue to hit sentiment.

EM equities remain highly geared into sentiment shifts - both positive and negative - and are also highly sensitive to domestic and international politics.

Asian equity

4

↓

As with EMs, Asia is benefitting from the reflation trade and loose monetary policies and a weak US dollar also provides a supportive environment. These economies have, on the whole, fared well through the Covid crisis but slower vaccination rates and China's recent moves against sectors such as tech have hit sentiment. Risks remain from the perspective of global sentiment as well as regional political tensions.

Property

3

↑

Property offers a reasonable yield pick-up compared to many other asset classes and price moves in 2020 imply that a lot of bad news is already factored in. Capital values are starting to rebound but rental growth is decelerating. There is also uncertainty surrounding a number of property types in a post-Covid world: the anticipated demise of the office and high street retail sectors could well be overstated but current pressures on tenants will have long-term repercussions.

Commodities

3

↑

Commodities have rebounded strongly off their lows and are not as attractive a value play today. Over the medium to long term, they should remain correlated to continued positive news on global economic activity. Broad allocations to commodities should also provide some protection if inflation surprises on the upside. Conversely, downward price pressure could resume if growth disappoints following the initial post-Covid recovery.

Hedge funds

3

↓

Given time, the right hedge fund strategy can provide a diversified return stream compared to more traditional asset classes. These funds are unlikely to keep up with a raging bull market but should post reasonable returns in a constructive environment for risk assets.

Absolute return

3

↓

Well-chosen absolute return vehicles can be a useful diversifier to overall portfolio risk thanks to their low correlation with traditional asset classes. But they are unlikely to keep up with ultimate safe havens such as government bonds in times of market duress.