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The three major trades you should be making in your portfolio, according to LGIM

22 August 2016

While LGIM’s Justin Onuekwusi has become much more cautious on risk assets over recent months, he says there are three areas of the market that could provide decent returns from here.

By Alex Paget,

News Editor, FE Trustnet

Energy stocks, UK mid-caps and emerging market debt are the three areas of the market offering the best opportunities in the current environment, according to LGIM’s Justin Onuekwusi.

Onuekwusi – who heads up L&G’s multi asset index range – recently told FE Trustnet that he had become increasingly bearish in his outlook for risk assets, having heavily reduced his exposure to equities due to his concerns about an inevitable financial crisis in China, the future direction of US interest rates and growing political risk across Europe.

“If you take a medium-term view, we think risk assets will deliver a lower return than their long-term average. Therefore, we are tilting the portfolios to be more cautious by, essentially, cutting our equity exposure right across the board since 24 June,” Onuekwusi said.

“We think the equity market reaction [to Brexit] has been driven by liquidity rather than fundamentals, rates being lower for longer, essentially, and that has pushed markets up to the levels we have seen today.”

However, the manager – whose funds are all outperforming their respective sectors since launch this time three years ago – isn’t just hoarding cash within his portfolios. Indeed, he says there are three areas in particular that can offer decent returns for investors going forward.

Performance of funds versus sectors since launch

 

Source: FE Analytics

In this article, he talks through the three areas and the reasons why he has been upping his exposure to them over recent weeks.

 

Energy

“For the first time in three years, we’ve become positive on energy,” Onuekwusi said. “We think the best way to access that is through energy equities and we’ve done that right across the board.”

As investors will be well aware, energy stocks have had a very tough time over recent years owing to a collapse in the price of oil.

According to FE Analytics, the MSCI AC World Energy index is down 7.09 per cent over two years. However, that compares to a 36.3 per cent fall in the oil price over that time.

Performance of indices over 2yrs

 

Source: FE Analytics

“You’ve had two years, effectively, of oversupply. You had the shale companies in the US producing oil and you had your traditional players such as OPEC and Russia. What happened is the shale producers produced more as marginal costs fell and that swamped the market in terms of supply,” Onuekwusi said.


“Historically, you have seen OPEC then reduce production and the price has gone back up. However, OPEC realised they were losing market share so therefore they simply didn’t reduce supply and they let the price fall as, by letting the price fall, it would put those shale producers out of business.”

“Now you are starting to see some of those shale producers stop producing.”

As the graph shows, though, both oil stocks and the price of oil have been in recovery mode over recent times and Onuekwusi says this trend will continue thanks to changing dynamics within the market.

“We think the market will move back into balance by the back end of 2016 or at least over the next six to eight months and that will mean the oil price will start to have some stability.” Onuekwusi added.

“We think the best way to get access to that is through those stocks that have been really beaten up by the fall in the oil price.”

 

UK mid-caps

Onuekwusi continued: “The other asset class we have become more positive is UK mid-caps.”

Following a stellar 2015 due to an improving UK economy and the surprise Tory majority at the general election, UK mid-caps (which tend to be more domestically-orientated than FTSE 100 stocks) have had a far tougher time of it this year.

Brexit uncertainty initially hurt the FTSE 250 index, though once the UK actually voted to leave the EU, mid-caps have been hit further by sterling weakness because of the impact the pound’s drop will have on their earnings relative to international-facing large-caps.

For example, FE data shows the FTSE 250 index has returned 4.42 per cent in 2016 compared to a 13.53 per cent gain from the FTSE 100.

Performance of indices in 2016

 

Source: FE Analytics

Onuekwusi says mid-caps were one of the key areas that he cut in favour of large-caps following the referendum – a decision that benefitted the portfolios.

“More recently, though, we have started to increase our exposure again because mid-caps are more domestically orientated and are lot of the underperformance has been driven by sterling,” he said.

“We think that sterling is getting towards the bottom end of its falls and that’s the first reason as to why we have increased our position in mid-caps. But the second reason is we now believe that a fiscal injection from the UK government is on the cards.”

“The size of that is uncertain, but that is bound to benefit mid-cap stocks over large cap stocks. It is bound to benefit the domestic economy more than your big mega-caps with global exposure.”

He added: “We are now at the largest allocation to mid-caps since the inception of the funds.”

 


Emerging market debt

“The last trade is essentially benefitting from the lower for longer environment. We know the Bank of England has reduced rates but we also know the Fed is erring on the side of caution given the political environment in Europe,” Onuekwusi said.

“That creates opportunities in rate-sensitive asset classes and two of them are global real estate securities, which is essentially 65 per cent biased towards US property companies and a lower rate environment clearly benefits those companies, and emerging market hard currency debt.”

Thanks to a general sense of nervous surrounding the developing world as a result China’s growth slowdown, a tightening of US monetary policy leading to a stronger dollar and falling commodity prices, emerging market bonds had been struggling over recent years.

Indeed, since the US Federal Reserve first hinted at ‘tapering’ its quantitative easing programme in May 2013, the IA Global Emerging Market Bond sector has posted a maximum drawdown – or the most an investor would have lost if they had bought and sold at the worst possible times – of 20 per cent.

Performance of sector since the ‘taper tantrum’

 

Source: FE Analytics

However, as the graph above shows, the sector has rallied considerably this year as there have been signs of stabilisation in China and comments from the Fed have become more dovish.  

While Onuekwusi does believe China will have a financial crisis over the next few years, he says a combination of rates staying low across the developed world and the current yields on offer (the average IA Global Emerging Market Bond fund now yields 5.76 per cent compared to a 10-year gilt yield of 0.5 per cent), the rally can continue over the short to medium term.

“It may be controversial given my views on China, but given the yield on emerging market hard currency debt, you’re looking at north of 5 per cent. In this low yielding world, that is pretty attractive and given that emerging markets have a lot of FX reserves, they are unlikely to default on their hard currency debt.”
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