Asset Allocator’s Soapbox: Time to put risk back?

Andrew Cole, investment manager for the Baring Multi Asset fund, on how much risk investors should be taking with their portfolios.

In this risk-on, risk-off type of year for the investor, right now we believe we are closer to the latter. Now is not the time to be putting risk back into your inflation-beating investment portfolios given the strong headwinds blowing in the form of higher energy prices and doubts over the soundness of the global economic recovery.

We are seeing sluggishness in Europe and North America as consumers appear unwilling to cut savings or extend their balance sheets, while wage growth remains subdued and disposable income is squeezed by higher fuel costs.

Inflation, which has been more acute in the emerging world, along with the hangover from the European sovereign debt crisis and its latest casualty – Portugal – are playing on the minds of the investor. We see further monetary tightening as central banks battle to keep a lid on price rises, which remain influenced by commodities.

Looking at recent asset allocation and fixed income, it is important to consider the level of reward we are being offered relative to risk. For example, in the UK, real yields on index-linked gilts are at a historical low and remain unattractive.

The environment is better in the US, but only just. Real yields there briefly touched 2% on 20-year US treasuries so we identified these as attractive and consequently bought inflation-linked bonds. Bond prices have since rallied and yields are back at 1.6%. The consensus remains bearish on the outlook for bonds but as uncertainty on the outcome for economic growth persists, we may see lower yields and opportunities could spring.

For corporate and investment grade debt, returns have been ‘equity-like’ for the last two years, but it is difficult to see how yield spreads will narrow from hereon, given the slow rate of growth.  

What about the outlook for equities and are investors continuing to be paid for taking on equity-related risks within their portfolios?

The equity risk premia is close to the UK long-term average of around 4.5%. But to get that you need to agree with the optimistic consensus for earnings over the next two years, and assume the market will ignore a rise in the cost of capital typically associated with a normalisation of real yields. For now, equities look the pick of a fairly ho-hum bunch of risk-related assets and are fair value at best.

One of the outcomes of the excess liquidity provided by central banks over recent years is that most assets have been rendered that bit more expensive relative to their long-term average. We believe a rise in interest rates in the UK or in the US, could lead to a higher risk premia across all asset classes.

Our exposure to government bonds focuses mainly on Australian and US debt, and our equity holdings are centered on UK and global multinationals.

We can see changes on the horizon however and will look to rotate into emerging markets and China. There, we expect the cycle of higher inflation and rising interest rates to have peaked by the end of the second quarter.    

We have reduced our positions in gold as we believe it no longer holds the risk diversification characteristics it did a few years ago. That said, recent uncertainties in the Middle East and sovereign debt default issues in some of Europe have kept the precious metal well bid and it would be foolish to exit the commodity altogether.

Other real assets we like include property and esoteric investments such as aircraft. Real assets help give that long-run inflation protection and we think, given that banks are increasingly constrained in their balance sheets, opportunities for multi-asset investors are emerging in those areas once dominated by the big banks.