For most of the past five years of investing in multiasset strategies, there has been a bull market for equities and bonds. Developed markets have outperformed emerging ones; ditto for the U.S. dollar versus other major currencies.
The extraordinary actions taken by central banks during and after the 2008–’09 financial crisis have helped drive much of this performance. Certainly, low interest rates have helped keep the economic engine humming. We at Baring Asset Management have seen a great deal of research over the past few months that suggests investors believe they have been lured into risk assets by central banks’ negative real riskless rates. This in turn has led to a general disbelief that current equity valuations are based on fundamental factors. Almost every market looks expensive, and bond yields are at historic lows, in part as a result of these extreme monetary policies. Equities are similarly expensive, especially considering the present optimistic expectations for earnings for the next few years.
One key event on the horizon is the Federal Reserve’s first rate increase, expected to happen before the end of the year. The fact that the Fed is gearing up for rate normalization, with the Bank of England expected to follow, does not help the equation for equities. Farther out, our ten-year forecasts, based on demographics, productivity, profitability and a host of other factors, are showing anemic returns. Our latest ten-year forecast for U.S. equities is to return 3.5 percent a year over the next decade. This particularly muted forecast is not encouraging.
In such a challenging market environment, global tactical asset allocation managers offer two very basic services: diversification and timing.
With regard to diversification, there is currently little opportunity in assets that traditionally offer noncorrelated returns, such as bonds, commodities and property. Of these, property has the best current valuation, and yet rising interest rates will likely impact all of these asset classes. Although we expect the equity market to be able to withstand initial interest rate hikes, we cannot rule out the possibility that the Fed gets behind the curve on inflation, especially with some of the signs of positive wage pressure we have seen recently. Therefore, we expect high-yield debt, property — by way of real estate investment trusts — and, to an extent, commodities to continue to be correlated to the risk of equities.
With regard to timing, we are more aggressive than most other multiasset managers about cutting exposure to equity risk when we perceive the market to be vulnerable. Since the past five years have seen a global bull market, we have not had a significant opportunity or need to cut risk in the U.S. product; however, we would anticipate the need to significantly cut risk in the next few years. Safe places to invest will be difficult to find.
Foreign exchange has also become much more crucial over the past five years. In a world full of so-called financial repression, it is not surprising to see national authorities treat their currencies with benign neglect at best — and a race to the bottom at worst. As a competitive tool, currencies provide not only returns to investors but also a medium for nondomestic earnings, thus affecting earnings expectations. The U.S. dollar’s recent strength is likely to persist, and therefore we would continue to use hedged non-U.S. markets as an opportunity for return and diversification.
The true test for multiasset allocation strategies will be as rates rise and central banks try to guide the world back to a more normal level of interest rates. There will likely be volatility and bumps along the way. Only investors who can dynamically allocate among different sources of beta will perform.
Hayes Miller is head of North American multiasset, and Matthew Whitbread is an investment manager; both on the Global Dynamic Asset Allocation strategy at Baring Asset Management in Boston.
