As markets are – at least temporarily – back in calmer waters, we decided to remove some of the negative qualitative overlays we had in our tactical government bond, equity and real estate allocation and to move back in line with our top-down signals.
Markets got into rough terrain in the second quarter
Short-term risks have receded…
During the first months of the year investors were plain sailing, helped by monetary policy, economic data and stronger currencies. Almost every asset class printed positive returns in euro terms. However, with the start of the summer markets got into rough waters as Grexit scenarios were pulled out of the closet and the Chinese stock market declined over 30% in a couple of weeks. As we are not thrill-seeking kite surfers, we decided to stay close to the coast and reduced some of our exposure in risky assets. Equities and real estate were scaled down to neutral and within equities we removed our preference for the Eurozone. On both issues, hitting the iceberg has been avoided. With regard to Greece a “deal for a deal” was agreed upon and the Chinese government has – not without effort – stabilized the Chinese A-shares market.
…although the sky is not totally clear
This is not to say that all of a sudden blue skies have returned. Greece has a long way to go and still needs a lot of hurdles to pass, but at least over the next couple of months it may no longer be daily front page news. Instead, the controversial (non)sense of the deal may only feed the discussions among economists and no longer influence markets. China from its side will probably need to restore some credibility in the eyes of international investors, as recent measures were not a good example of a liberalized market with free capital movements. Currently about 20% of Chinese A-shares are still suspended from trading. Hopes of a swift inclusion of A-shares in the MSCI index may be dashed for some time. This is occurring at a time of continued downward revisions of the Chinese growth outlook and a large debt overhang, complicating matters for a government that was counting on the equity market to solve balance sheet issues.
Equities and real estate back to overweight
However, as we are – at least temporarily – back in calmer waters, we decided to remove some of the negative qualitative overlays we had in our tactical government bond, equity and real estate allocation and to move back in line with our top-down signals.
As a consequence, we upgraded equities from neutral to a small overweight, which was our stance before Greece and China came to spoil the party. Positive drivers are the cyclical momentum, valuation and an improvement in price momentum. Next to that, we do not observe over-optimism among investors as witnessed by the low bull/bear ratio. In line with equities, we moved real estate from neutral to a small overweight. Fundamentals remain supportive, with the improvement in the labour markets in the US, Europe and Japan as an important driver. Even the Chinese property market is showing some signs of stabilization. Not only fundamentals are supportive, real estate also benefits from a yield premium as it yields around 200 basis points on top of corporate bond yields, almost double the long-term average. Biggest short-term risk is a US rate hike which in our view is insufficiently priced into the US bond market.
We also see less risk for an unwarranted increase in (German) government bond yields. The drop in commodity prices and the absence of wage pressures limit inflation expectations. Global monetary policy remains loose with the ECB announcing it will counter any premature tightening of financial conditions. Finally, price momentum in government bonds has improved. Despite the stabilization in Greece and China, we did not see any upward pressure on bond yields which makes us wonder whether there are other, less visible forces at work. As a consequence, we have upgraded our government bond positioning from a small underweight to neutral.
Hard times for commodities
A few weeks ago we made another change in our tactical asset allocation (TAA) as we downgraded commodities from a small to a medium underweight. Commodity prices have been under pressure in the past few months. Cyclical segments, most notably industrial metals and energy, have been hardest hit while also the price of gold declined to a five-year low last week. China has had a big impact on industrial metals. The ongoing economic slowdown, the struggle of the authorities to stabilise economic growth and on top of that the Chinese equity market turmoil all took their toll on resource prices. Concerns were affirmed last Friday as a survey showed that activity in China's factory sector seemingly contracted at the fastest pace in 15 months in July.
Also the energy sector has been on a downward trend since May, driven by declining oil prices. Stubbornly high OPEC production, uncertainty over the timing of expected US oil production declines, an approaching deal with Iran and expected demand fallout have sent oil prices sharply lower. Trigger for the sharp decline of late has been the surprise rise in US oil rig count. This was the first for the year, after an about 60% decline since last year’s October peak. US oil production and inventories also halted their decline. Markets therefore started to question whether the anticipated US production declines would materialize in the near term or would be delayed. At the same time, OPEC production continues to be on an increasing path, to which the Iran deal will further add. As regards oil demand, the turmoil in China – still the major oil demand growth contributor – and Greece dented oil demand growth expectations. Crude oil prices as a result tumbled, as did speculative net long positions.
In the longer term, it is difficult to become positive on commodities, as the outlook for (Chinese) commodity demand is still bleak.
TAA changes illustrate our approach
The changes in our TAA over the past weeks illustrate well the basics of our process. First, we do not follow blindly our navigation system but adapt if suddenly unexpected risks or opportunities pop up that are not fully captured by our framework. Secondly, it also illustrates our dynamic, flexible approach. We keep an open view on the world. If facts change, we do not hesitate to swiftly adapt our positioning to take into account the new reality instead of digging in our heels and hoping for a change in this reality.