Equity and fixed income markets are set for higher levels of volatility next year with a sell off particularly likely in bonds, according to Steven Andrew manager of the M&G Episode Income fund, who adds stock markets will offer the best returns.
In 2015 so far bonds and equities in the UK have spent most of the year showing some reversion to having their traditional inverse relationship, rising and falling at opposite times.
However, this has not been wholly the case and the respective broader markets are currently both almost identical in their low returns year to date of just under one per cent.
Performance of indices in 2015
Source: FE Analytics
Andrew, who heads the £421m multi-asset M&G Episode Income fund says equity markets will continue to offer better opportunities than bond markets over the next year but only due to “expensive” valuations in the latter.
“Most equity markets are not as cheap as they were two years ago but the significant equity risk premium remains the most compelling valuation signal today,” Andrew (pictured) said.
“We have to remember that this risk premium is because bonds are expensive, rather than because equities are cheap, and so we believe the prudent way to play this would be neutral to slightly overweight equity, and underweight bonds.”
However, he thinks there will be an increasing diversion between equity markets with two in particular offering the best returns.
“In our view, European and Japanese equity is priced for stronger prospective returns than US equity – although certain areas of the US market, such as banks looked attractive, especially given the potential to perform well in a rising rate environment.”
A further rally in these two markets would follow on from their strong gains returns this year. The IA Japan and IA Japanese Smaller Companies have offered the best returns taken on average in the Investment Association universe of 15.69 per cent and 14.08 per cent, respectively.
The IA European Smaller Companies sector is not far behind with the average fund up 11.94 per cent while the IA Europe ex UK sector is in the top quartile of sectors with a 5.27 per cent.
The worst performing sector this year, the IA Global Emerging Markets – where the average fund is down 7.66 per cent - could also offer decent value, he says.
“Some emerging market equity also seems attractively priced, but the level of genuine fundamental risk means we are engaging with these assets more modestly.”
Andrew currently holds 46.3 per cent in equities, a recent climb down from having nearly half of his fund in stocks which was his highest weighting for at least three years. The majority of this is still in the US and Europe. This reductions in equities is reflected mostly by a 3 percentage point increase in cash.
He has 30.4 per cent in government bonds although no gilts exposure, 13.6 per cent in corporate bonds and 5 per cent in property and just 4.8 per cent in cash. He has the majority of his government bonds at the longer end of curve.
His increased cash levels may be due to Andrew’s expectation of a bond market sell-off next year where yields will spike. He says, though, that he will be buying up this weakness.
“We believe mainstream government bonds, especially at the short-end, are generally overvalued, although we see some value at the longer end of the US curve.”
“The fact that the collapse in the yields to generational lows has persisted for so much longer than could be expected highlights how difficult it is to predict when this situation will change.”
“Nonetheless, we do expect yields to rise in 2016 and we are watchful for opportunities in this space.”
All in all, though, the manager says volatility is likely to be high across the market next year as many investors are still too jittery.
“Our sense is that the clearest explanation for this dislocation between price action and fundamentals is that investors, still traumatised by the shock of global financial crisis, are struggling to have faith in this growth and will require very strong evidence for a prolonged period to accept that a deep-seated recovery is indeed underway.”
“With sentiment so fragile and sensitive we expect volatility to persist for some time yet. However, it is important to remember that short-term volatility does not always equal long term risk, and often presents compelling opportunities for those with the emotional fortitude to take it on.”
Andrew has been at M&G since joining the group as an economist 10 years ago. He launched the M&G Episode Income fund five years ago in November 2010.
Sitting in the IA Mixed Investment 20%-60% sector, the fund has performed strongly against its peers with a top decile 37.69 per cent return versus a sector average of 24.33 per cent.
Performance of fund, sector and indices since launch
Source: FE Analytics
While the manager does not have a specified benchmark, as a mark of comparison he is ahead of both the FTSE All Share and the IBOXX UK Sterling Overall All Maturities indices over this period
Volatility has been much lower than the former index and marginally higher than the latter. Its maximum drawdown - the amount you would have lost if you had bought and sold at the worst possible times – is among the highest in sector, though.
Analysts at Square Mile Research point to Andrew’s focus on valuations for both fixed income and equities as being a key tenant of his success against his peers but that his “strong views” and high conviction plays can lead to periods of greater than average volatility.
His focus on income generation with the fund paying out every month has meant someone investing £10,000 at launch would have since earned £2,163 in income.
Income pay outs since fund’s launch
Source: FE Analytics
The M&G Episode Income fund’s current yield is 3.62 per cent and it has clean ongoing charges figure [OCF] of 0.81 per cent.
