Central banks flood the markets with liquidity: Fed’s QE3, Bank of England’s QE4, Bank of Japan’s QE9... ECB non conventional policy is more subtle, taking the form of an off-balance sheet item, the well-known 'Draghi put'. As a result, so-called risk free rate are everywhere kept at artificially low levels.
Exiting these ultra accommodative policies will take time. The U.S. economy is showing signs of recovery, primarily driven by the housing market recovery and lower energy costs, but this improvement remains fragile due to, among other things, a more restrictive fiscal policy. We expect sluggish growth in the coming years, with a very gradual decline in the unemployment rate.
We do not expect a bond crach, but we do not see any value in highly rated bonds offering yields below 2%. We prefer credit, whose spreads reward the extra risk taken, though the absolute yields remain historically low.
In the search for yield, equities appear particularly attractive. The risk premium is inflated by low interest rates, but dividend yield often exceeds the cost at which issuers refinance their debt. Many firms have a lot of cash on their balance sheets, which will spark buybacks and M&A. Finally, many institutional investors are largely underweighted for regulatory reasons.
As of end of March, however, the portfolio is very defensive though: equity exposure is about 25%, versus 37% earlier this year. Why? The weight of the continental Europe has been temporarily reduced: our caution stems from a lack of visibility on Italy and the consequences of the Cyprus rescue. Moreover, Euro zone latest macro figures are worrying. We favour European companies whose revenues are global and whose valuations remain attractive, especially oil and pharmaceutical values.
Emerging equities are over-represented with 11% of the portfolio: This wager has not paid off in the quarter, but we wish to remain contrarian, after two years of strong underperformance. We keep a high weighting in the UK, both on large caps (FTSE 100), which are globalized societies, but also on the midcaps (FTSE 250), whose valuations are attractive. Regarding U.S. equities, we took some profits given the impressive performance indices in the first quarter.
We actively manage currency exposure: the foreign exchange market seems gradually guided by fundamentals. We are structurally buyers of emerging currencies, not only through equities mentioned above, but also purchasing debt in local currency, both sovereign and private. We use the U.S. dollar in the active management of the portfolio's overall risk.
Finally, we maintain a small gold position. Certainly, QE3 tapering out from the Fed in the favorable scenario of U.S. recovery will weigh on gold prices. But this position, at odds with consensus, is a cheap multiline insurance: if the U.S. recovery fizzles out, against certain extreme risks in Europe, covering the resurgence of inflation in some emerging countries, and more generally acting as a refuge in a context where the exacerbation of currencies war would lead to a relapse of investor confidence.