Our asset allocation stance has evolved back to a balanced stance with somewhat above-average opportunities for excess returns seen in equity and real estate markets, while a negative return outlook remains for commodities.
Liquidity drives cash-flow assets higher
Liquidity theme is back in full force
Markets seem to be feeling a bit better again after ECB President Draghi hinted at an expansion of the central bank’s quantitative easing (QE) program at his press conference on October 22. With the Fed having postponed its first hike in nine years and the biggest Asian central banks either easing already (China) or getting closer to move again (Japan), the easy money theme is back in full force in the market environment. In such an environment many investors will put on some sort of a “liquidity trade” that tries to exploit the impact that abundant liquidity will have on future asset class returns.
Different from positioning based on stages in the business or credit cycle or general “risk-on/risk-off” swings, the liquidity trade creates a backdrop where both risky and safe assets perform well. Basically it causes all assets that have a claim of future cash flows to perform well. The latter can be either coupon or dividend payments that cause an asset owner to outperform cash over time. This means that generally safe categories (government bonds), yield plays (credit and real estate) and growth assets (equities) all do well once the liquidity trade is in play.
Commodities remain unattractive in a liquidity drive market
The big exception in such an environment is commodities. This asset class (historically) offers a negative carry due to the need to gradually roll down the futures curve while being invested in commodities (unless you want to store the physical stuff). Moreover, owning commodities does not provide any claim on future cash flows. Only when tight demand-supply conditions for commodity markets cause persistent spot price appreciation will a commodity investment generate excess returns over cash. That is generally not the environment that investors associate with one where global central banks are inclined to maintain or even expand their easy policy stances. As long as investors see excess supply, modest growth and global disinflation, commodities remain relatively unattractive in a world of ample liquidity.
Liquidity is a dominant market force since July 2012
One could argue that ever since markets became convinced that the ECB and the Bank of Japan (BoJ) would join the Fed in its willingness to “do whatever it takes” with its liquidity ammunition to reflate the economic system, the liquidity trade has been one of the most dominant forces in financial markets. The graph below illustrates very nicely how this has impacted the relative performance of risky assets like real estate, equities and commodities.
Obviously, other factors have also been at play (most notably the lingering emerging market (EM) growth crisis), but ever since Mario Draghi made his famous speech on 26 July 2012 on potential ECB action to support the euro, commodities have lagged other risky assets dramatically. The political and policy regime shift in Japan that followed Draghi’s words in late 2012 (Shinzo Abe won the elections and the appointment of a new BoJ governor was announced) made sure the three largest central banks in the world were firing on all liquidity cylinders to fight of global deflation risks. Where equities and real estate floated up more than a cumulative 50% since this liquidity wave started rolling, commodities actually have sunk 30% since then.
With hints now returning that the liquidity theme has become more dominant again, we tilted our asset allocation stance somewhat to better accommodate this environment. We upgraded equities from neutral to a small overweight and downgraded commodities from a medium to a large underweight.
Other factors supportive of equities
For equities, other elements play in the background as well. The earnings season is mixed, with strength in the technology sector compensating for weakness in the commodity and industrial sectors. Expectations of analysts are generally beaten by a standard margin. Furthermore, we see ongoing activity with regard to initial public offerings (IPOs) and mergers & acquisitions (M&A). We also see resilience in global growth momentum, with tentative signs of bottoming in emerging markets while sentiment among investors is still low and positioning still on the defensive side.
For commodities, the rapid fading of the short-squeeze has been noteworthy and the supply-demand imbalance has not healed yet. Both Chinese demand and the unfolding inventory correction in the global goods/manufacturing sector continue to weigh on commodity pricing.
Return of the search for yield in spread markets
The improved liquidity environment is also supportive to spread products and could lead to a return of the “search for yield”. Nevertheless, at least in the initial stages, we expect this search to be cautious, probably leaving out the categories most exposed to the factors that drove the correction in the first place. As such, EM categories and commodity exposed pockets may initially be left out of the loop. Furthermore, valuations obviously have improved due to the sell-off. Spread levels for a majority of spread products are currently either above or around the long-term averages. In fact, only during outright crisis situations, like the Eurozone sovereign crisis in 2011-12 or the subprime crisis in 2008, spreads have been above current levels. This holds in particular for US high yield and investment grade credits and EM sovereign debt in hard currency.
On the other hand, the credit cycle may be close to a turning point which argues for caution. Global M&A is rising rapidly as is corporate leverage, in the US in particular. Corporate defaults are rising as well and particularly in commodity exposed segments may shoot up further. Also the structural nature of China’s slowdown unlikely to alter quickly. So far, these risks are still contained. All in all, our stance on spread products is neutral.
Preference for equities and real estate
Putting it all together, it now means that our asset allocation stance has evolved back to a balanced stance with somewhat above-average opportunities for excess returns seen in equity and real estate markets (both a small overweight), while a negative return outlook remains for commodities (large underweight). We expect fixed income, both government bonds and spread products, to do better than cash but only roughly in line with their historical excess returns over cash. Although these expectations have a horizon of three to six months, we always remain open-minded and ready to adapt them if the facts change.