REBALANCING UPDATE AND MARKET COMMENTS: January 2020
Since the last quarterly re-balance, while showing strong positive returns across all portfolios, the portfolios demonstrated considerable under-performance against their corresponding benchmarks. This relative under-performance was a result of our overall defensive stance, which was expressed through a large proportion of Developed Government Bonds within the total bonds allocation and selecting low volatility funds as primary instruments to implement exposure to equity markets within the portfolios. A small part of the under-performance against the benchmarks was also due to the under-weight of GBP exposure, as a protective measure against a hard Brexit.
Despite this recent shortfall, the portfolios performance remains strong year-on-year, both in absolute terms and relative to the corresponding benchmarks.
Looking forward, we continue to combine strategic allocations through models with tactical adjustments, based on our current cautious view on global markets.
Apart from the obscure US political developments, such as the introduction of trade tariffs, the USA-China deal and a potential presidential impeachment, there are also some worrying figures coming from global markets. The equity market is macro-economically expensive: the ratio of the US equity market capitalisation, represented by the Wilshire 5000 Index, to US GDP has reached 150% during the last 3 months, above its previous all-time high of 140% reached in 2000 before the market selloff of 2001-2002. Interest rates are at their record-low and the assets owned by the three largest central banks, as a result of Quantitative Easing, are currently close to $13 trillion compared to $1.3 trillion at the end of 2000, raising the question of whether the banks have enough power to effectively tackle any potential market crisis.
Different economic agents are cognisant of these market risks. One of the measures of forward-looking risk assessment is the readiness of commercial banks to lend. Commercial and Industrial loans are contracting at the largest US bank, with JP Morgan reporting a 3% decrease year-on-year. Bank of America is pulling back on credit card lending at a time when credit card interest premiums are at their all-time highs, around 15%. Large banks are tightening their Personal Loan Lending Standards, for the first time since the end of 2007. In short, risk takers are taking money off the table.
The UK regulators are also concerned about a potential market crash. FCA chief and the next Bank of England governor Andrew Bailey has said that a drop in the markets is one of his biggest concerns, as there is a lack of understanding amongst investors of what the consequences of “a major fall in asset prices” could be. Bailey has also noted that the pension freedoms introduced in 2014 left UK investors retirement savings ‘far more exposed to asset prices”.
There is a considerable chance that we are at the end of one of the longest bull markets and at a setup stage of a large market event. With bonds yields at historically unprecedented low levels, there is a limited safety in increasing Government Bond allocations, with most of the potential rate cuts already reflected in the bond prices. Therefore, in this re-balancing we have considerably increased the allocation to Investment Grade bonds at the expense of Government Bonds – a move which targets both an increase in yield and a reduction in average duration, mitigating the risk of losses from rising interest rates. The re-allocation is most significant for higher risk programs, and almost negligible for low risk, defensive portfolios. We also continue to express the equity allocation through low volatility indices which, we believe, are the most adequate at this late stage in the market cycle.
Our Optima Range fund selection remains essentially the same for the main asset classes. We have introduced a new ESG ETF by BlackRock into the European equity allocation, which adds an ethical aspect to the portfolios. Alternatives are expressed through infrastructure and renewables, both of which had a good year, but are now facing some head wind from potentially raising rates. We kept this selection as a source of different risk premium and an opportunity of policy-driven upside. A relatively large part of the Commodities allocation is placed in Gold as a hedge against political risks, inflation and raising rates.
At the end of last year, Fusion introduced a new set of portfolios – Fusion Active Range – to UK retail clients. It has essentially the same Strategic Asset Allocation as the Optima range, but has more potential for tactical tilts and uses primarily actively managed mutual funds rather than low cost ETFs. The Active range is more suitable for investors who believe in managers skill and expect to earn additional long-term returns from active market timing and individual asset selection implemented by specialist fund managers. Unlike the Optima range, the Alternative allocation for Fusion Active portfolios is split between convertible bonds and Real Estate funds, therefore being closer to the more traditional understanding of Alternatives.