The art of diversification
21 November 2017
Almost half the companies listed on the major developed country indices have published their third-quarter 2017 results. The good growth figures of recent quarters are, logically, now bearing fruit, with a marked rise in revenue (+5% in Europe; +7% in Japan) and earnings up by between +7% in the USA and +16% in the eurozone.
However, there were more positive surprises in the USA than in Europe. Meanwhile, bond yields are still at record lows (0.38% for the 10Y Bund) and the ECB announced on 26 October that it would reduce its monthly asset purchases, but extend the programme until September. Investors will therefore be tempted to be strongly overweight in equities - particularly Japanese and eurozone securities - and underweight in the bond markets. Each of these bets is highly logical in view of the fundamentals, although the construction of a portfolio that is well balanced portfolio in terms of risk cannot be seen as just a simple sum of fundamental convictions, since these may potentially be correlated.
Moreover, the strong dollar is boosting export earnings and Japanese and European equities in turn. A strong dollar is often linked to a more expansive fiscal programme or a more restrictive monetary policy, and therefore higher government bond yields. As such, holding Japanese and European equities and at the same time being low in duration does not provide sufficient diversification. This correlation was particularly apparent in early 2017, with the combination of a drop in bond yields, the underperformance of Japanese and European equities and the fall in the dollar.
Beyond our management convictions, a crucial part of our asset allocation work involves identifying the key exogenous factors that will influence the performance of the various asset classes, in order to construct a balanced risk allocation in relation to these factors, while it is difficult to anticipate the path such factors will follow.
For now, we remain positive on eurozone equities, which are benefiting from strong growth. We are maintaining diversification in Japanese equities, which have been boosted by the highly accommodative monetary policy of the Bank of Japan and a sharp rise in earnings. Diversification in emerging equities and emerging debt is still a relevant issue for us, given the ongoing rebound in activity, especially as these asset classes are benefiting from a weaker dollar, unlike our bets on eurozone and Japanese equities.
In the developed market bond component, we remain negative on German bonds, as their level does not reflect the marked improvement in the eurozone economic cycle. On the other hand, we see the very long end of the US curve as attractive, as it can be a shock absorber for any equity market bumps, and is also much cheaper than the German curve in view of its fundamentals.
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