Monday, March 4th, 2013

Coming Soon – Second Quarter Nerves

In each of the last three years, there has been a sell-off in risk assets at some stage during the second quarter. It hasn’t happened in the same month and it hasn’t always affected every asset class, but there have normally been losses to deal with. Should we be worried, even though we have only just past the end of February? There are plenty of reasons to be concerned – Italian elections seem to have decided nothing, sequestration is now a reality in the US and exchange rates remain volatile. But it is hard to argue that these outcomes were not fully discussed in recent weeks or that there has been a huge shift in behaviour.

Our view is that investors should take some risk off the table and have already begun to do so. The most obvious example is in Europe, where the weight of risk assets in the tactical asset allocation model has fallen from 70% at the end of January to 65% at the end of February. There is no overriding reason, just the gradual evolution of risk and return over time. Risk conditions have improved slightly (excess volatility is lower than it was a month ago), but the momentum of excess returns has begun to decay. This looks and feels like the beginning of a consolidation phase.

We observe the same process in our US model, where risk assets have been reduced from 85% to 82%. Other changes are consistent with a narrative of consolidation. Within equities, the model has added to developed equities and reduced emerging markets; the largest percentage reduction is in commodities; the weight of corporate bonds has fallen while that of government bonds has risen.

The only region where the model is not more cautious than a month ago is the UK. This is not because UK equities are fundamentally more attractive than US or European equities. It’s simply a function of what was happening elsewhere. Holding UK government bonds during the period when they were downgraded, in a month sterling was falling fast, was never going to be winning strategy. The UK model has to take risk, because the alternative is not exactly risk-free at the moment.

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