An impending rate rise in the US is likely to cause a sell-off in bond markets and a potential 8 per cent correction in equities, according to L&G’s Justin Onuekwusi and Lars Kreckel, who have been upping their exposure to cash, short-dated corporate bonds and property in preparation.
With China’s equity market showing signs of calm following its recent crash and a ‘Grexit’ (albeit possibly temporarily) avoided, market attention has once again turned to the future of US interest rates with many expecting a hike either in September or later in the year.
Though the reasons behind a rate hike revolve around an improving economy, many warn that even the smallest of increases could cause volatility in both bond and equity markets – which are trading on historically high valuations thanks to six years of ultra-low rates and quantitative easing.
Another major concern is that the two asset classes, which have tended to move independently, are now highly correlated (as the graph below shows) leaving investors with far fewer places to hide in the event of a correction.
Performance of indices since April
Source: FE Analytics
Kreckel, global equity strategist at L&G, says that while the bull run in equities is likely to continue over the medium term, the asset class will be unable to dodge an interest rate-induced sell-off in fixed income – which he believes will occur before 2016.
“It is typically a situation where you get a bit of a wobble in equities. It isn’t something that usually derails a bull market or causes a recession, but you tend to see investors getting nervous that the Fed might be making a policy mistake, such as they are too early and will choke-off growth or they are too late and inflation will get out of control,” Kreckel said.
“What has happened in the last few decades when the Fed has done a first rate hike is that it wasn’t a policy mistake and that equity markets recovered relatively quickly.”
“But there is that period of uncertainty and if you look at back at history, on average there has been an 8 per cent correction. As we head into the second half of the year, it is something that is making us a bit more cautious than we would normally be at this point in the cycle.”
This caution has been reflected in the position of Justin Onuekwusi’s L&G Multi Index range.
Since he took charge of the range in August 2013 following stints at Aviva and RBS, Onuekwusi has outperformed his peer group composite with returns of 15.13 per cent by running more ‘risk-on’ strategies.
Performance of Onuekwusi versus peer group composite since Aug 2013
Source: FE Analytics
However with a potential rate hike on the cards, he has “substantially de-risked” his portfolios. Taking his £65m L&G Multi Index 3 fund as an example, he has increased his cash from 9.5 per cent last month to more than 15 per cent today.
“Overall, there is more cash in the funds than there has ever been before. We are at the highest allocation we have ever had to short-dated corporate bonds and we have reduced our equity allocation to the lowest level it has ever been,” the manager said.
Onuekwusi is by no means alone in upping his weighting to the money market, as the recent Bank of America Merrill Lynch Fund Manager Survey showed that cash weightings are now at their highest level since the collapse of Lehman Brothers.
JOHCM’s Ben Leyland recently explained to FE Trustnet why he holds 17 per cent of his Global Opportunities fund in cash.
“Our cash balance reflects the lack of value in the equity market, in particular the unfavourable risk-reward balance in absolute terms,” Leyland said.
“Cash gives us two huge advantages: it protects capital in a market sell-off and allows us to take full advantage of opportunities when they present themselves, as they did for example last autumn in Europe.”
While Onuekwusi says cash is the “ultimate diversifier”, he adds that there are other areas of the market that look attractive in a rising interest rate environment.
“Since we started managing these funds we’ve been saying that as we get closer to the Fed’s lift off-date we will increase our short-duration exposure. When equities and bonds have both fallen, they have delivered better returns than those two asset classes, again giving us protection against yield movements.”
Onuekwusi uses direct securities and exchange traded funds (ETFs) within his portfolios for exposure to short-dated corporate credit, but there are a number of highly rated options in the actively managed space for investors to consider.
One of which is the £260m AXA Sterling Credit Short Duration Bond fund, which is headed up by Nicolas Trindade and carries an ‘A’ rating from Square Mile.
“About 20 per cent of the portfolio matures each year, which gives some protection against any future rises in interest rates, as the manager should be able to re-invest maturing bonds at higher yields,” Square Mile said.
“Generally speaking the fund is likely to behave in a defensive manner, performing well relative to the wider corporate bond market during periods of volatility and negative returns, but lagging, perhaps substantially, during periods of strong returns.”
While the fund has (albeit with a very low level of volatility) considerably underperformed its peers in the IA Sterling Corporate Bond sector since launch in November 2010, it has come into its own in 2015 as longer-duration assets have plummeted in price as yields on German bunds, US treasuries and UK gilts have spiked.
Performance of fund versus sector and index in 2015
Source: FE Analytics
It has been a top decile performer year to date with a slight positive return of 0.9 per cent and a maximum drawdown of just 0.63 per cent.
The fund, given the area of the market it invests in, doesn’t yield a great deal though at 1.3 per cent so should really be viewed as just a step up from cash on the risk spectrum. It has an ongoing charges figure (OCF) of 0.43 per cent.
The other area of the market Onuekwusi is positive on is UK commercial property.
“You can see that UK property has been a strong performer. It is a standout asset class in terms of expected risk-adjusted returns. That is mainly down to two things. Firstly, increases in rents in both primary and secondary properties but also an increase in transactions not only in London but elsewhere in the UK.”
“UK property did show that it can give you protection when both bonds and equities fall, as they have done over the last quarter.”
While the asset class was massively out of favour thanks to its performance during the financial crisis, UK commercial property has become increasingly popular as the economy has recovered and investors have looked for an alternative source of income outside of bonds – delivering very strong returns in the process.
Since the notorious ‘taper tantrum’ of May 2013 when the Fed warned it would reduce quantitative easing, the average ‘bricks and mortar’ UK property fund has considerably outperformed both bonds and equities with returns of close to 30 per cent.
That outperformance has continued in 2015’s topsy-turvy market.
Performance of funds versus sectors and index since the ‘taper tantrum’
Source: FE Analytics
While concerns have been raised about the future of the asset class and the current cash drag funds within the sector have thanks to huge inflows, the average IA UK commercial property fund still yields 4 per cent.
Onuekwusi’s favourite vehicle of choice is the £2.1bn L&G UK Property fund, which is run by Matt Jarvis and FE Alpha Manager Michael Barrie.
The fund, which yields 3.5 per cent and has outperformed its average peer over one and five years, is highly diversified by region as while it owns areas of central London such as on the Strand and in the City in its top 10, it also owns the likes of the Argos Distribution Centre in Stafford.
It must be pointed out, however, that the fund (which has an OCF of 0.63 per cent) holds less than 70 per cent in direct property. The rest of the portfolio is in REITs and cash, largely as a result of its high inflows.
