Squaring the portfolio paradox: Risk re-allocationClick for graphical depiction of asset allocation, courtesy of UBS.
Equity and credit valuations are ‘fair’, global growth remains uneven, and in 2010 market volatility may increase. Yet we opt to increase allocations to equity, credit, commodities, and real estate for 2010. Why? A gradually improving global economy and the prospect of higher policy rates undermine the case for government bonds, nominal and inflation-linked. Cash returns remain unattractive. Stocks and corporate bonds are likely to out-perform, along with commodities and selected REITs. But in a world of lower returns and higher volatility, increased allocations to ‘risk’ assets only makes sense if accompanied by a lower cyclical profile in terms of sector and style. Squaring the portfolio paradox (lower risk-adjusted returns but higher allocation to risk assets) requires a redistribution of risk within the portfolio.
What to avoid: Bond markets
By early 2010 investors will anticipate the end of the Fed’s ‘zero-rate’ policy and will expect rate hikes elsewhere, as well. Rising short rate expectations will push up bond yields, as well as bond market volatility. The appropriate asset allocation is to reduce bond holdings and shorten duration in fixed income portfolios.
Milestones and catalysts
Important investment signposts include a peaking of US unemployment (by Q1 2010), validation from the Fed and other central banks that growth is sustainable (by Q2 2010), and healthy corporate profits growth (Q4 earnings season). Upside risks to our view include the advent of asset price bubbles (above all in Asia). The chief downside risk remains a faltering US recovery.
Revised asset allocation
Our revised allocations are as follows. We increase overweight allocations to global equities and high-yield corporate bonds, and move REITs and ‘soft’ commodities from market-weight to overweight positions. We reduce our government nominal and inflation-linked bond weightings to underweight. Finally, we retain our maximum underweight position in cash.
Sounds very much like consensus bank reflation case...