Risk assets have further to run this year, write JPM Fusion Funds managers Tony Lanning and Nick Roberts.
Last year saw the S&P 500 index in the US generate a return of 32.4% - its best performance since 1997. We are now well over five years into the recovery following the global financial crisis and, with the S&P 500 having returned 203% since bottoming in March 2009, it is perfectly legitimate to question how much longer the good times can last.
We have already surpassed the average bull market return over the past 47 years of 179%, while, at 57 months, the duration of this bull market is slightly less than the average 67 months witnessed over the same time period.
However, while history can often provide insights into the expected behaviour of asset prices, we place limited importance on it in this case. Each bull market is different and the protracted nature of the economic cycle that has accompanied this rally gives us confidence that further equity gains lie ahead.
How much longer can the good times last?
In a typical cycle, we would probably now be transferring from the recovery to the inflationary slowdown phase. However, because this recovery has been so anaemic and there remains a huge amount of spare capacity, the inflationary pressures are simply non-existent.
We are anticipating an acceleration in global economic growth in 2014 as fiscal drag starts to ease, business investment picks up from highly depressed levels and credit conditions thaw further. The large amount of spare capacity in the system, combined with the recent fall in commodity prices, will ensure that inflation is not a problem. In fact, the threat of deflation will ensure that monetary policy remains ultra loose.
An environment of non-inflationary accelerating economic growth is most constructive for risk assets. Equities and credit should perform well in such an environment and it should be no surprise that we are overweight both asset classes and have been increasing risk further in recent weeks.
A barbell approach
However, we have to recognise that risks still exist and that 2013 was all about a re-rating in equity markets. Earnings growth stagnated last year and the strong gains in most developed world markets were achieved purely through multiple expansion.
While we cannot rule out a further re-rating, especially given that equities remain attractive relative to other asset classes, we need to start seeing earnings growth coming through in order to justify some of the valuations we are observing. Any failure to do so will increase the chances of markets suffering a correction.
While we wait for confirmation that the recent pick-up in economic activity will feed through into higher earnings growth, we are adopting a barbell approach to portfolio construction.
High conviction equity positions, both strategic and more tactical, are being balanced with assets we believe will provide protection should the economic or earnings outlook disappoint.
Unlike many who have entirely written off the asset class, we include core government bonds as an area that is likely to protect portfolios in such an eventuality.
We believe that the ‘QE premium’ embedded in government bonds has now largely evaporated and that they now trade more on fundamentals. Any material disappointment in economic growth would be likely to see them perform well.
As such, we continue to own treasuries and gilts across our portfolios but in varying degrees. However, as our growth outlook has improved over the past few months, we have been steadily reducing exposure in favour of cash.
In fact, cash levels in the portfolios are beginning to look elevated relative to history. Finally, the portfolios also have notable exposure to non-correlated absolute return strategies whose returns bear little relationship to risk assets. Funds such as Melchior European Absolute Return and Pioneer Absolute Return Bond are good examples.
In the face of accelerating economic growth and little inflationary pressure, equity markets will continue to make progress in 2014, although there is certainly an element of earnings catch-up required.
With this in mind, a barbell approach of high conviction risk-on positions, balanced by the most efficient hedges, makes most sense to us. Any material correction in markets would be likely to see us further alter the balance more in favour of risk assets.
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