Our current tactical posture
Our current recommended tactical posture (the three to six month tilts we suggest to your long-term asset allocation mix) speaks of our concern that capital markets still have a way to go before they more accurately reflect the likely path of US interest rates over the next couple of years as we see it. These expectations have already moved some way. However, the fact that we are recommending clients remain tactically underweight commodities and emerging markets (EM) equities, as well as sticking to a very light and low duration footprint in the fixed income universe, reflects our view that there is further to travel for US interest rates across the curve yet.
This week, we are looking to discuss the Emerging Markets Equities component of a diversified portfolio. In spite of our concern that further rises in the US yield curve and a likely stronger dollar may see EM equities continue to stumble as they have in the last month, our longer-term conviction in the asset class remains undiminished. We see EM equities contributing strongly to portfolio performance over the next five to ten years as continued increases in emerging markets’ consumer disposable income creates a strong long-term bid for the space.
Developed world bond markets have again had a tough week amidst better data out of the US and a little more optimism around Greece. In the US this week, it was retail sales that were the highlight, with positive revisions to the previous months and a strong May figure suggesting that there was less to worry about in the first place and that the prospects for consumption remain robust. We also received a little more good news on the job market from the NFIB (National Federation of Independent Business) survey of small businesses in the US, which provided further ballast to the idea that the US jobs market is nearly healed, with further wage inflation surely inevitable. Meanwhile, in Europe, the vague contours of a deal between Greece and her creditors gained a little more definition in spite of the continued posturing by both sides and accompanying negative headlines. The upshot of all this is that the bond market looks a little more vulnerable and the prospects for a slightly steeper path of interest rate normalisation in the US a little more assured.
Rising interest rates across the curve in the developed world have coincided with a softer showing from Emerging Markets Equities, much as our Tactical Asset Allocation team feared when they recommended cutting exposure to EM equities back in March. The most obvious historical precedent for such underperformance linked to US monetary policy is the mid to late 1990s. In 1994, tighter US monetary policy heralded a sharp and prolonged period of EM equity underperformance, culminating in the Asian Financial Crisis. In spite of this alarming precedent, it is worth pointing out that the block as a whole is in much better shape than in 1997. In particular, EM countries’ external debt positions are much better than in 1997, as are their fiscal positions. For these reasons, we do not envisage as lengthy a setback for EM equities as the US Federal Reserve begins to normalise monetary policy this time around.