indicator
Asset Allocation
Q1 2015
At a glance — our asset class views
equities
bonds
currencies
US
US & UK government
US$
Europe
EU & Japan government
EUR
UK
Inflation linked
GBP
Japan
Investment grade
JPY
Asia ex Japan
High yield
EM
Emerging markets
EMD
Views of Investec Asset Management’s Multi-Asset team and reflect relative preferences within respective asset class. Directional views for
bonds reflect projected price movements. As at 31 March 2015.
Neutral
Strongly up
Sharply down
Trending up
Trending down
Market review
rates. The size of individual cuts varied between 15 and 100
bps. Some countries made more than one cut over the
quarter with Denmark winning the accolade for the most
— the Nationalbank cut interest rates four times within the
first three months of the year. Outside of the aftermath of the
global financial crisis, the number of rate cuts seen over the
first quarter of 2015 was truly extraordinary compared to
historical precedence. Perhaps what is more remarkable is
Central bank action dominated proceedings in the first
quarter of 2015, with 36 interest rate cuts seen across the
globe. The European Central Bank (ECB) finally introduced
quantitative easing (QE), the Swiss National Bank (SNB)
surprised markets by scrapping the Swiss franc/euro cap
and the US Federal Reserve’s (Fed) communications left
investors no clearer about its future intentions.
Uzbekistan set the scene for the quarter with a 100 bps
interest rate cut on 1 January, and what followed was a
further 25 economies, as diverse as Australia to Albania,
China to Canada, and Romania to Russia, deciding to cut
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1
indicator
never before has so much attention been paid to the
presence or absence of the word “patient” in the Federal
Open Market Committee minutes. Speeches from different
FOMC members also suggested an increased reliance on
data in making their decisions. As such, the mixed economic
data seen over the quarter, with strong payroll numbers
countered by muted growth and subdued inflation, meant
there was enough for those expecting a near-term interest
rate hike and for those expecting a delay in lift-off, to both
conclude that their views were right.
the fact that Denmark, Sweden, Switzerland and the euro
zone each ended the quarter with negative deposit rates.
This is truly uncharted territory for central bank policy,
making it challenging to assess the long-term
consequences.
The reasons cited behind these cuts varied on a case by
case basis, but a large part of it, whether publically stated or
not, was the self-preservation of economic competitiveness
given the risk of currency strengthening. This was
particularly of relevance for certain European economies
worried about the knock-on impact from the significant
depreciation of the euro that foreshadowed and followed the
ECB’s QE announcement in late January. When the
announcement finally arrived — after months of debate,
leaks and preparation — the actual size and length of the
programme (€60 billion per month until September 2016)
took many by surprise. As would have been expected
though, in addition to a falling euro, European government
bond yields fell yet further, while European equities rallied.
The prospect of a ‘Grexit’ did not dissipate over the quarter
though, and following weeks of bluffs, political posturing and
mud-slinging, we ended the quarter no closer to a resolution
around Greece’s future in the euro zone.
Despite widespread concerns about perceived elevated
asset price valuations, the potential for disruption from
geopolitical risks such as a possible ‘Grexit’ and generally
unfavourable economic data, attractive returns were
available for investors over the first quarter of 2015. Within
equities, Europe was the standout performer as the market
reacted positively to QE, while Japan also had a strong
quarter of performance on the back of improving return on
equity levels. The yields of most developed bond markets
again finished the period at a lower level than they started,
the US dollar continued to strengthen, credit provided
modest returns and property again flourished. Commodity
assets, however, again suffered over the quarter, while
emerging market local currencies and bond markets
marginally weakened.
In a classic case of ‘don’t believe everything you hear’, days
after both the Chairman and the Vice-Chairman of the SNB
publicly confirmed their support for the Swiss franc/euro cap
that had been in place since 2011, the SNB performed an
astonishing policy U-turn and removed the cap in midJanuary. This decision resulted in a significant appreciation
of the Swiss franc and a sharp fall in Swiss equities, while
challenging perceptions around the SNB’s credibility and
central bankers more broadly.
Equities
Equity markets provided positive returns over the first
quarter of 2015. In local market terms, Europe (18.9%) and
Japan (10.5%) were the standout performers. Asia ex Japan
(4.9%) and the UK (4.2%) also experienced strong returns,
while emerging markets had a solid quarter (2.2%). US
equities, for so long the best performing market on a relative
basis, failed to keep up with other regions, although did eke
out a positive return (0.8%). The significance of the US
equity market in a global context meant that global equity
returns were dragged down (2.3%).
Central bank communication was also an important
consideration in the US, as market participants searched for
clues on the intentions of the Fed in the timing, and
subsequent path, of future interest rate hikes. For example,
Figure 1: Equity returns (expressed in local currency terms)
35
30.7%
30
25
22.3%
18.9%
Percentage (%)
20
15
10
10.7%
4.2%
5
0
12.0%
10.5%
6.3%
0.8%
TOPIX
Q1 2015
S&P 500
12m to 31.03.15
FTSE 100
6.0%
4.9%
2.3%
Developed markets
(MSCI)
Source: Bloomberg
2
2.2%
Europe ex-UK
(MSCI)
Asia ex-Japan
(MSCI)
0.4%
Emerging Markets
(MSCI)
indicator
that we are not comfortable with. Taiwan is one exception
where the risk-reward trade-off looks attractive.
We continue to believe that the bull market in developed
market equities has further to run. These equities are
unlikely to peak until closer to the end of the business cycle,
which in our view, looks some way off. Supportive policy,
steady but not spectacular economic growth, and a low
inflation environment all provide a helpful backdrop for
equity returns. Nonetheless, valuations appear fair on
average, rather than cheap, and so future returns look set to
be primarily driven by earnings growth rather than a further
re-rating.
Bonds
Yields on 10-year government bonds in the US, Germany
and the UK again ended the quarter lower than where they
had started, although this does not tell the whole story as
yields fluctuated within a range. Each of the UK, Germany
and Japan 10-year bonds reached a record low yield at
some point during the quarter.
Within developed market equities, we continue to favour
Japan given attractive valuations, the backdrop of
supportive economic and policy reform, and positive — but
not excessive — momentum and sentiment. We have also
started to see strong and yet still improving underlying
earnings growth coming through which further supports our
thesis. We believe the prospects of Asia Pacific excluding
Japan have improved, particularly in Hong Kong, with
attractive valuations primarily driving this view, supported by
a positive view on property fundamentals. Our enthusiasm
around Europe and UK has dampened somewhat since last
quarter. Europe’s significant re-rating in the first quarter of
2015 has made the valuation case less compelling, although
we do acknowledge improving macroeconomic
fundamentals in the region. The UK offers both reasonable
valuations and fundamentals, but the recent significant flow
of money into this region has made us more cautious. The
US market continues to offer high quality and attractive
fundamentals, but in our view it does not look attractive from
a valuation perspective.
Spreads between nominal and real bond yields (known as
inflation break-even rates) bounced back higher in the US,
Germany and Japan, particularly at the shorter end —
where shorter-term inflation expectations are reflected — as
the market re-calibrated previous expectations about the
extent of disinflation in these economies. Break-even rates
remained more or less the same in the UK, though with
some intra-quarter volatility. Credit spreads narrowed
modestly across the developed market space with high yield
bonds reversing some of the prior quarter’s widening.
European high yield credit, in particular, benefited from the
positive sentiment post the ECB QE announcement.
Emerging market local currency bonds were once again
adversely impacted by the strengthening US dollar, while
emerging market hard currency bonds achieved a modest
gain as investors sought out higher yielding dollar assets.
We believe that real yields in developed markets will remain
lower over the medium term. The prospect of steady growth
and low inflation, along with the reliance on unconventional
monetary policies (such as the aforementioned QE and
negative deposit rates) to stimulate the economy, lead us to
conclude that it will still be a considerable time before we
return to ‘normal’ interest rate levels. In addition, some
central banks, such as the Bank of England (BoE) and the
Fed, have implied that the terminal interest rate they
eventually reach is likely to be at a lower level than
We continue to believe that while emerging market equities
appear cheap on most metrics, they currently lack a catalyst
for clear outperformance. Economic data and earnings
continue to disappoint as a result of weak trade growth,
falling commodity prices and slowing Chinese demand.
There are some pockets of compelling value, but in most
cases these come at the expense of taking a degree of risk
Figure 2: Bond returns (expressed in US dollar terms)
10
7.2%
5.6%
5.2%
5
1.6%
Percentage (%)
0
-5
-2.5%
2.1%
2.0%
0.3%
-2.5%
-4.0%
-5.5%
-10
-11.1%
-15
Citigroup WGBI
All Maturities
Q1 2015
Source: Bloomberg
Citigroup WGBI US
BofA Merrill Lynch
Global High Yield
BofA Merrill Lynch
Global Investment
Grade
12m to 31.03.15
3
JP Morgan GBI-EM
Global Diversified
(Local ccy)
JP Morgan
EMBI Global
(Hard ccy)
indicator
Currency
historically has been the case, further suggesting that
‘normal’ times are a long way away.
The US dollar strengthened against most developed and
emerging market currencies over the quarter, appreciating
almost 9% on a trade-weighted basis, by 4.9% against
sterling and by 2.4% against emerging markets. QE from the
ECB led to the euro depreciating 11.3% against the US
dollar, 6.6% to sterling and 11.0% to the Japanese yen. The
combined effects of the SNB policy U-turn and ECB QE led
to the Swiss franc appreciating by over 15% against the euro
over the quarter.
As detailed earlier, it is clear that we are in a period of
increasing divergence in policy responses between the US
and other economies. The debate in the US is centred on
the timing of rate hikes, while other economies are still in the
midst of cutting rates. This calls for flexibility and selectivity
with owning developed government bonds. We do not rule
out US Treasuries as a potential investment though, and as
with UK, Canada and Australian government bonds, they
offer a relatively attractive yield to other markets such as
Germany and Japan. Our preference for these markets is on
investing further out along the yield curve and/or to position
for changes in the shape of the curve.
We continue to remain positive around the US dollar as we
believe the fundamentals of the economy are robust and
— as noted above — the US is most likely to return to policy
normalisation sooner than the other major economies. We
acknowledge, however, that shorter-term pull backs may
occur given it appears to have been overbought, and also
the mere extent to which it has rallied in recent months.
We remain cautious about credit markets, for both
investment grade and high yield bonds, due to the scale and
quality of issuance, increased leverage levels and the extent
of investor crowding in these markets. However, we
recognise that the accommodative monetary policy in the
global system provides a strong backdrop for these markets,
and so believe there is potential for modest returns.
We remain cautious around sterling given weakening
economic data and the risks relating to political uncertainty
in the run up to the General Election in May. Additionally, it
was not too long ago when commentators suggested an
initial rate hike by the BoE would have happened by now,
but we are now actually at a stage where BoE policymakers
have spoken of a potential rate cut. Hence the BoE’s
stuttering monetary policy represents another potential
headwind against sterling, especially given that interest rate
hikes still appear priced in. Notwithstanding these
comments, we believe that sterling’s weakness relative to
the US dollar ended up overshooting too far over the first
quarter.
We believe that emerging market local currency debt offers
a decent risk premium for investors. These markets should
also be supported by soft inflation and reasonable economic
growth. However, selectivity is crucial and the countryspecific balance of payment situations should determine the
relative winners and losers. In particular, the impact of lower
oil prices and the sensitivity to US dollar appreciation are
two important factors to take into account when assessing
which positions to own. We believe emerging market local
bonds offer better value than hard currency bonds, and this
view has been strengthened given the recent divergent
performance between the two markets.
The direction of travel for the euro seems clear over the long
term, with a further depreciation likely to take it to parity and
beyond relative to the US dollar. However, over the shorter
term we believe there is scope for a partial recovery by
the euro.
Figure 3: Currency returns
35
28.3%
30
25
20
16.0%
15
Percentage (%)
5
0
13.8%
12.6%
11.3%
10
7.2%
5.1%
0.3%
-5
-2.4%
-10
-9.7%
-15
USDJPY
Q1 2015
USDEUR
USDGBP
12m to 31.03.15
Source: Bloomberg
4
EM ccy index (versus USD)
GBPEUR
indicator
slow, desynchronised nature of the recovery has left the
global economy with plenty of spare capacity; we expect the
expansion to continue for a more protracted period than
historically has been the case which, alongside low interest
rates and inflation, will support Growth assets. Equities
remain our favoured Growth asset.
The strengthening US dollar may have the biggest impact on
emerging market currencies. That said, there are selective
buying opportunities available, particularly for those
economies with improving trade balances and with the
potential to benefit from government reforms such as India
and Indonesia.
It is our view that attractive returns are still achievable in this
environment. We believe a focus on fundamentals in addition
to valuations, exploiting a broad opportunity set and
maintaining a flexible approach are important characteristics
for generating returns in the current environment.
Conclusions
Following a weaker first quarter we expect an improvement
in the growth backdrop over the year, supported by easy
money from accommodative monetary policy and the
effective ‘tax cut’ provided by falling oil prices. Overall, the
Thought of the quarter — strange days
shown gradual improvement, has rocketed over the last six
months. Lower oil prices, if sustained as we think they will
be, are like heavy rainfall after a drought and will provide a
substantial boost to consumers in the US and elsewhere.
The dramatic rise in the dollar that has occurred against all
world currencies since July 2014 appears to have been a
barometer of the change of gear in the US economy,
suggesting that it was already emerging from the more
general slough of weak growth before the effect of weak oil
prices has been felt. Certainly, the rapid contraction of the
formerly buoyant energy sector in the US and the
disruptions at the ports on the country’s west coast may
obscure the trend in the near term, but in our view, the
expansion is now sufficiently broad-based to stay the
course. In time this will help provide more general global
economic traction resulting in growth finally exceeding,
rather than disappointing, consensus expectations. In the
cases of Japan and the euro zone this could happen sooner
than economic forecasters suspect in response to the
lagged impact of material currency weakness and other
stimulatory measures.
As we approach the sixth year of the current economic cycle
there are constant reminders of just how unusual it has been
by past comparison. The dramatic fall in the oil price,
renewed conflict in Ukraine, the political backlash against
austerity in Europe, the ECB’s announcement of QE, and
lenders having to pay borrowers to take their money in a
number of countries have added to the sense that we live in
abnormal times (see Figure 4). Growth has generally
remained stubbornly sub-par despite highly stimulative
monetary and fiscal conditions. China’s spectacular growth
rate has stuttered and the commodity boom has turned to
bust. In a more ‘normal’ cycle this would be the time when
investors would be worrying about diminishing capacity,
overheating and monetary tightening — the kind of
conditions that normally bring the party to an end. At such
times investor sentiment has typically been euphoric,
whereas, despite strong performance from developed
market equities and bonds in local currency terms, this time
sentiment has remained brittle. As the Doors’ Jim Morrison
once sang, these are indeed ‘Strange Days’.
Such a backdrop remains constructive for markets. True,
increasingly divergent monetary policy trajectories are likely
to result in higher volatility, but a steady and improving
growth picture should usefully underpin corporate earnings
growth, while low inflation and continued loose monetary
policies ex the United States should keep real short and
long term interest rates low. Against such a background,
developed market equity valuations are reasonable and
should deliver positive returns. Developed market bonds
may even extend their secular bull market to an incredible
34 years. European, US and Japanese property assets
should also be well supported. Emerging markets may
experience a bumpier ride though. Equity valuations are
relatively cheap, at least in aggregate, but operating
performance remains poor and we suspect that currencies
may need to adjust further. After the end of a long cycle it
So what is 2015 likely to hold and where are we in cyclical
terms? The world economy continues to labour in the twin
shadows of the global financial crisis and natural end of the
long Chinese boom. The former weighs heavily on the
developed world, whereas the latter continues to depress
the emerging market world. Caught in such cross currents,
individual country cycles are highly de-synchronised,
evidenced in weak commodity prices and persistent
deflationary pressures. Debt levels that many thought would
have to decline - the ‘New Normal’ — have done the
opposite. Deleveraging has been missing in action. However,
there is a strong case against excessive pessimism about
the future. The gestation period has been a long one but the
key US economy appears to be back on track. Consumers
have retrenched, the banks have been recapitalised and are
now lending normally, and consumer sentiment, having
5
indicator
To conclude, it is too early to call the end of the current
cycle. It is likely to be an unusually long one with several
more years to run. In the meantime market cycles have been
impacted by quantitative easing and financial repression,
most notably in bond and credit markets, hence cyclical
financial market inflection points are likely to be reached well
before the end of the economic cycle, but that is unlikely to
be the challenge of 2015. Jim Morrison also once
proclaimed that ‘this is The End’, but this is a sentiment we
do not agree with.
would be unsurprising if there were not a few high profile
casualties before it is safe to declare the all clear. Typically,
new emerging market cycles are incubated in periods of
reform and India may be pointing the way here.
Figure 4: 1 month LIBOR rates
7
6
5
4
3
2
1
0
-0.5
-1.0
-1.5
2007
USD
2008
JPY
2009
GBP
2010
EUR
2011
CHF
DKK
2012
2013
SEK
Source: Bloomberg
6
2014
January 2015
February 2015
March 2015
indicator
Important information
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The information discusses general market activity or industry trends and should not be construed as investment advice. The economic and
market forecasts presented herein reflect our judgment as at the date shown and are subject to change without notice. These forecasts will be
affected by changes in interest rates, general market conditions and other political, social and economic developments. There can be no
assurance that these forecasts will be achieved. Investors are not certain to make profits; losses may be made. Past performance should not be
seen as a guide to the future.
The information contained in this document is believed to be reliable but may be inaccurate or incomplete. Any opinions stated are honestly
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assurance purposes.
Issued by Investec Asset Management, April 2015.
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