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We are at an unusual juncture in global financial markets, with the impact of the coronavirus shutdowns, combined with more nationalist policies, leading to divergence in economic growth and asset prices worldwide.
Episodes of idiosyncratic market volatility are also more frequent and severe. This has led us to be especially well diversified in our global equity exposure, and to be holding more cash than usual to capitalise on sudden asset price swings. We believe that being more interventionist through more active tactical asset allocation, as well as taking on more and smaller bets in portfolios, are among the most effective ways to add alpha amid the global recovery from the coronavirus crisis.
In the debate around “transitory” versus longer-lasting higher inflation worldwide, we believe investors cannot conclude that higher inflation will necessarily become a more permanent feature of national economies and result in much higher interest rates and future stagflation as some are forecasting.
The pandemic saw unprecedented and unplanned shutdowns across national economies. Producers cut costs and reduced capacity. Supply chains have consequently had difficulties gearing back up to meet surging consumer demand, which has recovered quickly amid the reopening of economies, in turn causing supply bottlenecks and rising prices.
The extremes of the economic downturn, and its following rapid rebound, mean we cannot predict when supply and demand will rebalance across different sectors. Pricing mechanisms still need to fully adjust. So in our view it is premature to say whether we have an inflation problem.
Equally, predictions of longer-lasting higher inflation ignore that global growth is being driven by several structural engines, namely the recoveries in three main regions: the US, Europe and China. All of these are proceeding at different speeds, and it is impossible to determine how their combination will affect the overall rates of global growth and inflation over the nearer term.
The US recovery has been steady, with bouts of financial market instability, while the EU has registered permanently weak growth, combined with periodic financial stress coming from the peripheral economies such as Greece and Italy in the absence of central bank support.
China’s economic cycle is much further advanced, having already fully recovered from the Covid downturn and now slowing in response to policy tightening. We cannot know how these dynamics will play out, so we believe it is best not to be wedded to one inflation view.
While there are still attractive investment opportunities in global markets we believe careful diversification and more active management and intervention are needed to get the best results from an offshore portfolio, due to the relatively expensive valuations and higher volatility now prevailing.
Based on current asset valuations we currently prefer global cash and diversified global equities in our asset allocation. Global developed market bonds remain expensive across most maturities, so investors are paying up or even losing money for their diversification and duration benefits.
In bonds, we have identified some attractive opportunities in emerging market government bonds, such as Chile, for example, that should add value to portfolios over the medium term. Episodes of bond market volatility and mispricing have increased significantly, especially since the onset of the Covid pandemic, making it advantageous to adopt a more active tactical asset management approach to derive added alpha from the asset class.
We have thus been taking advantage of mispricing more frequently, buying and selling assets more quickly to add alpha to client portfolios. Having higher levels of cash on hand for flexibility in tactical asset allocation is important in executing this strategy, which has been somewhat unusual for M&G in the past.
As for global equities, we consider the MSCI all country world index (ACWI) to be reasonably priced from a historical perspective. With valuations trading around fair value, our portfolios are positioned broadly neutrally from an asset allocation perspective. Within the asset class, however, we are quite selective in our equity exposure, holding more but smaller positions to limit downside risk.
This is due largely to the wider divergence across company earnings, sectors and national policies, and different growth prospects worldwide that have prevailed in recent times. Some geographies such as the US are relatively expensive, while emerging markets and Europe are cheaper. Equally, some global sectors, such as tech are expensive and others, such as banks, offer value.
While certain global equities are offering excellent return potential compared with bonds and cash, others could represent value traps. For example, when the share prices of Chinese tech companies plunged in response to news of additional government regulation earlier this year, we believed it was a good opportunity to buy Tencent because of the company’s diversification and underlying resilience in earnings.
However, when the Turkish lira plunged this year due to political interference in the central bank’s monetary policy, we acknowledged that the much higher uncertainty created could cause a value trap. One has to know when to avoid an asset despite its cheapness, and to have a clear idea of what its fair value should be.
So though global investing conditions are unusually complex, as fundamental valuation-based managers we are finding good opportunities to add alpha to portfolios by adopting a more interventionist and diversified investment approach, and by not relying on a single view of the future.
• Lonergan is portfolio manager for multiasset and macro funds at M&G Investments (UK).
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Published by Arena Holdings and distributed with the Financial Mail on the last Thursday of every month except December and January.