The dynamic nature of today's markets means pinpoint exposure to isolated themes is valuable. David Millar, head of multi-asset at Invesco Perpetual, shares two key calls.
An unconstrained research agenda gives us the freedom to achieve true diversification, which is necessary in order to negotiate the changing dynamics of global markets.
Once we have looked across asset classes and geographies for long-term investment ideas, the next step is to apply robust risk management tools in order to bring the ideas together. The key is how all the ideas work together and, importantly, how they interact with each other to reduce overall risk.
Traditionally, many investors have relied on the diversification benefits of holding both equities and bonds in a portfolio. However, over the years, the correlation between the two asset classes has been constantly changing.
Pre-2001, bond yields were, on average, a lot higher than they are now. When bond yields rose during the 1990s, equity markets responded negatively because the higher level of bond yields was not being fully offset by higher growth.
However, in 2001, after bond yields followed base rates to historically low levels, the relationship between equities and bonds changed significantly. When bond yields rose, equities also headed higher because the higher bond yields generally reflected stronger economic growth, which more than offset the increase in the cost of equity.
We have been in a multi-year period of low bond yields and, once again, the relationship between equities and bonds appears to be changing. Since the start of 2012, a positive correlation between bond and equity prices has been seen once more.
For much of the period, that was because falling bond yields, partly as a result of central bank bond purchases, also acted to push up equity prices. In the second quarter of 2013, however, bond prices fell and yields rose at the same time as equity markets weakened.
These changing correlations underline the importance of a diversified portfolio able to pinpoint exposure within markets to isolate key macro themes without being restricted by asset class labels.
Australian interest rate market
For example, across the developed world, we expect monetary policy to remain accommodative. One idea our team has focused on is the Australian interest rate market and how it is currently pricing in interest rate rises.
The Reserve Bank of Australia (RBA) has its work cut out as it resides over a transition in the economy from one that has been highly dependent on commodities for growth to one that is more services-led. After lowering its policy interest rate to 2.5% in August, the RBA suggested it did not expect to cut rates again imminently, which led to a broad expectation it had reached the end of its rate cutting cycle.
The two-year interest rate swap yield is 2.9% and the expectation of the two-year swap rate yield in two years’ time is 4.3%.
However, we believe growth pressure is unlikely to alter in the near future and have bought a two-year forward, two-year swap, which, even if rates remain on hold, will fall towards current two-year swap levels and contribute a positive return.
Another opportunity we see is in the European financials sector, where we believe corporate bonds offer some value. The current regulatory environment suggests banks, which dominate the financials index, will continue to need capital to further bullet-proof their balance sheets while defaults seem highly unlikely, especially as central banks, including the European Central Bank, seem committed to ‘saving’ the banking system from past excesses.
At the same time, we believe the current spread of senior financial credit already reflects the regulatory environment and the sector’s low earnings visibility and, therefore, spreads could narrow. This makes us comfortable taking a long position on European senior financial credit. We combine this trade with a long volatility position on the Euro Stoxx Banks index.
The slow pace of both economic growth and change in the European banking sector has led to low earnings visibility, which means bank equity may come under pressure in the years to come.
This, coupled with the currently low implied volatility of European banking stocks, represents an attractive entry point and adds some defensive qualities to the trade. Meanwhile, if things do go wrong in the sector and credit spreads rise to reflect increased risks, equity volatility levels will most probably increase.
Both of the examples here show how we isolate a specific theme and act on it, rather than needing to be exposed to particular markets or asset classes through traditional asset allocation. In addition, the use of volatility as a source of potential returns acts as another great example of how to diversify exposure by going beyond traditional asset types and labels.
Correlation between US equities and US bonds has moved in three broad phases since the 1990s
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