Why we are taking our equity overweight to neutral for first time in five years

Is the post Brexit market recovery justified?

One of the most significant developments of 2016 to date has been the UK voting to leave the European Union, a decision that has led to huge uncertainty, both politically and within the UK domestic economy. The FTSE 100 has rallied in part because of the translation effect of a very weak sterling boosting profit forecasts, but the FTSE 250 – after an initial sell-off – has also recovered.

To my mind, there are a couple of other factors driving these rallies. The twists and turns of the political landscape have been hugely unpredictable, but the fact we now know who the next UK prime minister is – and that Theresa May is in place much earlier than we had expected – is certainly in the short-term a fillip for markets and has helped settle investor confidence.

But we are living in an extraordinary time, with profound central bank intervention and influence on markets. As macro-economic risks have grown, central banks have turned the taps on and provided liquidity to bond markets, where core yields have collapsed. There is a perception – amid this unprecedented central bank action – that core bond yields could grind ever lower and that is forcing investors to look for yield wherever they can find it, which has helped underpin risk assets.

It is far from clear when this situation might end. Central banks are acting in response to global deflationary forces washing around the system, coupled with an inability of governments to spend money or implement structural reform – and it is difficult to see when these factors will change. Clearly, investors have learnt in recent years that, faced with torpid growth and an abundance of developed world QE, they have few places to go other than equities.

At some point, yields will rise but it may not be imminent as central banks will endeavour to keep yields low to encourage growth. Until they do, banking profitability may be depressed – and in such an environment banks may be less likely to create credit, undermining economic growth. However, despite this, with falling gilt yields we find ourselves in the situation where UK equities are yielding four times what a ten-year gilt is yielding. It is no surprise that investors chasing a nominal return are therefore turning to risk assets.

But, clearly, this rally feels somewhat unjustified and unsupported by the fundamentals. There are going to be a number of headwinds facing the UK economy as it detaches itself from the EU over the coming years, which will likely reduce economic activity in the UK and impact domestic profits.

Moreover, at some stage we are going to have to contemplate the possible impacts on the broader economy of the US election result, while disharmony could yet break out within the European Union. We are also mindful of the global debt burden and global overcapacity, and are particularly alert to the alarmingly high levels of non-performing loans in the Italian banking system, as well as China’s ongoing attempts to rebalance its economy.

Portfolio positioning

Against this backdrop of growing global risks – which does not feel like the backdrop to positive equity returns – we have decided to take equities back to neutral across our asset allocation portfolios, after favouring the asset class for over five years.

Drilling down, we have reduced our exposure from overweight to neutral in Europe ex UK, the UK and Asia ex-Japan; and we have increased our exposure to the US and emerging markets up to neutral from an underweight position – areas that seem somewhat further from the eye of the storm. We retain a very small overweight in Japan.

In Europe, the vote to leave the EU has effectively served as a stress test on European banks, where profits and adequate capital were already fragile. But despite the Euro area making reasonable progress in recent quarters (with rising wages and consumption, revived capital expenditure and an easing of austerity measures) these indicators need to continue growing at a time when Brexit will put them under pressure. Indeed, the key leading indicator for economic growth – money supply – is rolling over again, while current account surpluses remain large and non-financial debt remains very high.

While in dollar total return terms, European equities are 29% below their pre-global financial crisis peak, we see risks for earnings growth against the backdrop of broader monetary policy from the ECB and the Italian banking system’s issues.

Meanwhile, in Japan, we are seeing modest movement in the economy, but decades-long deflation and poor demographics are headwinds the region is struggling to overcome. That said, we’ve seen corporate governance reform in Japan coming through, with companies increasingly focusing on return on capital employed, profits and their shareholders – which are positive for the economy on a medium-term outlook.

Globally, structural reforms are needed in many places in the world if we are to get the growth agenda moving, but they are difficult to implement, particularly against today’s macro-economic backdrop.

Several of our macro concerns will also impact European credit. The European banking system and regulatory change remain worries, but further policy stimulus and a limited supply in European area corporate bonds is delivering a powerful demand for high yield credit assets. European high yield also has more defensive characteristics than equities and offers better risk-adjusted returns with short duration. We are thus in favour of European high yield but our allocation to credit remains neutral.