Tuesday, September 3rd, 2013

De-Risking in the New Old-Fashioned Way

The decision on whether to reduce the risk of an investment portfolio remains as difficult as ever. The front pages are full of the latest on the Syrian crisis and the business sections still concentrate on the timing and impact of the Fed taper. There are plenty of reasons to be worried, and it is clear from our models that investors in the US and Europe have been looking for ways of reducing their exposure to risk.

The old-fashioned way of achieving this was to increase one’s holding of government bonds, and buy put-options on equities if you were really concerned. Within equities the normal tactic was to reduce exposure to Emerging Markets and add to the US and the UK, and reduce the weight of cyclical and financial sectors in favour of defensives such as Consumer Staples and Utilities. Some of this still works (e.g. reducing exposure to Emerging Markets) but it looks as though some of the playbook will have to be revised.

The most obvious example is government bonds. The main risk is the withdrawal of QE forcing yields to rise, particularly at the long end of the curve. The policy originates in the US, but it will have an impact on all government bond markets unless the host government – e.g. Japan – intervenes in the opposite direction. International diversification will be of limited benefit. Our models suggest that investment grade corporate bonds are now the principal beneficiaries of flows out of the equity markets. There may be structural reasons for this, such as the greater availability of ETF’s, but investors seem to be betting that an improvement in credit quality will allow credit spreads to narrow even if benchmark yields are rising. This is working across all our asset allocation models, in euros, sterling and dollars.

At the sector level, the de-risking dynamic seems either not to be working yet, or to have some strange effects. Our sector models in Japan, Europe, US and UK all suggest that investors are reducing their exposure to Consumer Staples (tobacco, food, beverages etc.) at the same time as they are reducing their exposure to equities. This used not to happen. The Telecom and Utility sectors are also in the bottom half of the table, and show no sign of rising strongly, except in countries where there is large scale M&A activity.  Instead investors prefer cyclical sectors like Industrials and Consumer Discretionary (both are at or near the top of our sector rankings in all regions). This makes sense if you believe in the recovery, but it can’t be described as de-risking in the old-fashioned way.

Most of our clients agree that they have taken some risk off the table since the end of the second quarter, but in this – as so many other things – we are witnessing the onset of another “new normal”.

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