As we head into the summer months, investment managers say the market is heating up and they are struggling to find fair value homes for their clients’ money. Fixed income yields little, while the FTSE 100 has flirted with all-time highs at several points since the start of the year.
With both equities and fixed income looking expensive, and the emergence of macro-political concerns in Eastern Europe and the Middle East, there are fears we are due for a correction.
‘We are in a situation in the US, Europe and other developed markets where equity valuations are not cheap, as people have been adding risk to their portfolios for the last 18 months,’ said Kerry Craig, global market strategist at JP Morgan.
‘From the end of December last year, the expectation was that core government bond yields would rise as earnings went up, but yields [have fallen]. At the same time as equities looked fairly valued, bonds became more expensive and that caught investors out.’
As a house, JP Morgan still favours equities, but at a more modest overweight than last year, when the FTSE returned 20%, a feat it is unlikely to replicate in 2014.
‘We still think it’s the right place to be but given where valuations are, it’s about finding quality companies - it’s about looking at the micro as well as the macro,’ Craig said.
‘The fact that markets are high means investors have to be much more careful about where they are investing, and looking for earnings growth coming through.’
‘Another risk that could add volatility is central bank policy, with [Bank of England governor Mark] Carney or [Federal Reserve chair Janet] Yellen bringing about a rise in interest rates. A few months ago, Carney said rates would not rise until the middle of next year. Now he is saying that could happen sooner than expected, and investors have to prepare themselves for this.’
While government bonds could hardly be described as good value, Craig argued they do have a place in a portfolio, as they will protect you if there is a big macroeconomic scare, the one thing that really could prompt a correction in markets at the moment.
‘They do provide an important place in a diversified portfolio because they provide security, so if you do get a flare up in Ukraine, or a civil war in Turkey, you get that protection from volatility and a layer of reassurance.’
James de Bunsen, a manager on Henderson’s multi-asset team, is holding a cash weighting of 10% in cautious portfolios. He believes unexpectedly strong economic growth could tighten monetary policy, spooking markets in the process.
‘We are a bit concerned that growth will be better than most people expect, perversely, as that could be bad news for most asset classes,’ he said. ‘We are still holding cash, which we do not like holding, but it is the only thing we can rely on to give us a bit of security if we get a wobble.
‘If the numbers come through stronger than [central banks] and the market thinks, then they could feel they need to raise rates more quickly. Too much growth is one of the things we are mindful of because that will affect everyone. If bond yields move up, it will affect equities as well. Everyone will run for the hills at the same time, and cash will be the only place to take cover.’
He cautioned investors against buying local currency emerging market debt in their quest for value, as he thinks valuations there are misleading.
‘Areas that look cheaper like emerging markets are slightly misleading because while on a headline basis they look cheap, that is because there are some huge state-run companies in there. They are cheap for a reason – namely that they are not run for the benefit of ordinary shareholders.’
Instead, the multi-asset team have taken about 2% out of high yield bonds and put it in to dollar-denominated emerging market debt.
Rob Burdett, co-head of F&C’s multi-manager team, has responded to the current lack of value by including an allocation to alternatives such as infrastructure and specialist property.
‘We are underweight fixed income, and neutral to equities. We are plugging the gap with absolute return funds and alternative assets which should be more immune to issues in the market should they arise.’
He said there are not too many signs of ‘irrational exuberance in the market,’ suggesting investors are already exercising a degree of caution. However he added he had spoken to some managers in his portfolio, who had ‘taken the heat out’ of their allocations following the violent reversal out of mid caps in April and May.