Chris Leyland, True Potential Director Of Investment Strategy, looks back on the key themes around the True Potential Portfolios over the past month.
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Global interest rate setting is US led. US inflation may have peaked or is very close to peaking, its settled level may end up higher than the Federal Reserve’s (Fed) 2% average inflation target. As inflation falls pressure on the Fed to become less aggressive in raising interest rates will abate – this will provide a measure of support for risk assets. There are nuanced views tied to falling US inflation, particularly, the shift from slowing growth to one where demand starts to form a firmer base. This will take time, creating winners and losers.
- The economic situation in Europe and U.K. is more problematic from an inflation and demand perspective than the US. Defensiveness and active selection are more appropriate for UK and European markets.
- China is grappling with the need to restore domestic demand requiring more central support for consumers and the property market. We envisage this will be forthcoming, and equity valuations are cheap. We need to see some evidence on the data front to move more constructive on the region, and more broadly emerging markets.
- If inflation remains sticky sovereign bond yields will not recede to prior historic lows but corporate credit should gain some support. Defaults will increase but not in a major systemic way.
A critical element for positive rewards accruing to risk taking is not just the cost of capital but its degree of stability. The cost of capital looks as if it will settle moderately higher with inflation higher this cycle. But as investors adjust to this reality the cost of capital will stabilise and be a net positive for businesses.
In respect of the above, corporate profitability will come under further downward pressure. However, cheaper equity valuations compared to the start of the year offer some protection. Investors could look through profit declines if the demand environment is deemed better 12 to 18 months out. Equity allocations remain low relative to history but constantly reviewed. At this juncture, we are not looking to take equity allocations lower. Opportunistic additions to sovereign fixed income and increasing duration have occurred but little appetite to be significantly longer duration until inflation becomes more controlled.
Background/Positioning
Assets prices enjoyed a more favourable start to the month of August, more recently markets have been challenged as the battle between inflation peaking and the direction and magnitude of monetary policy.
Against the background outlined above, equity weightings have reduced within the True Potential Portfolio proposition since the start of the year. Over the month, action has taken place to marginally increase exposure to equities. The True Potential Balanced Portfolio has reduced from 59% to just over 53%. We are not currently minded to reduce equity exposure downward. The shape of the equity book has changed over the course of this year. Additions have been made to more defensive equities. Examples include Swiss equities, healthcare and minimum volatility equity products.
Opportunities are being found within fixed income. Higher yields in sovereign bond markets, though still negative in real terms, are providing some compensation. The True Potential manager cohort continues to add to this asset class and lengthen duration but require signs of inflation stabilising before moving further. Corporate bonds, deemed less attractive than sovereign bonds with spread levels not providing sufficient compensation in the current environment. There are nuances here with stock pickers and income managers identifying selective opportunities within single names and being able to select bonds they believe fully discount risks that may lie ahead. The challenge, however, is that higher yields are making primary debt issuance challenging, thus supply is limited. For context in the US a typical year would see $450bn of primary issuance, this year markets are tracking for $140bn. In European high yield markets, the next issuance is not expected until September.
Alternative weightings have increased as we continue to look at differentiated sources of return. With fixed income now offering higher yields, alternatives are possibly less attractive. Nonetheless, they offer diversification benefits. Good quality alternative sources of risk premia are still valued. We have a range and are not reliant upon one single environment for them to be a diversifier.
Past Performance is not a guide to future performance. Tax rules can change at any time. With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest.
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