Summary

• Reduce emerging market exposure across DAA portfolios (-1%)
• Allocate to cash (+1%)

This takes our equities underweight at the portfolio level to -4%, which is slowly starting to become substantial.

As always, when you are diverging away from the benchmark (or in this case, from our strategic weights) it can feel uncomfortable. That discomfort stems from the fact that growth is going to be absolutely gangbusters over the next few quarters, and it can feel somewhat discombobulating to sell down growth assets given that backdrop.

Equally, we feel that the blockbuster growth is likely going to be paid for by tax rate hikes, meaning that corporates won’t necessarily participate to the full extent of the broader economy (i.e. great for Main Street, maybe not so much Wall Street), and that markets, being forward looking, have already largely digested (and priced in) the “explosive growth” narrative.

As such, we’ve already trimmed our developed and local (Australian) exposures, and we now trim our developing market exposures.

DAA positioning

Strategic

We table below our strategic asset allocation for equities. We normally expect to have an exposure of 2-5% of the portfolio in emerging markets equities through the cycle depending on the risk profile of the portfolio.

Multi-asset performance

The reasoning for the reduction is fairly straightforward: equities are enjoying a very strong showing, with international (both developed and emerging) performing well, alongside Australian shares. The MSCI Emerging Market Net Total Return index is second from the top by way of performance over the last three years.

Wall of worry

Shares in general have climbed the wall of worry, and it’s been a while since we’ve needed to add a fresh set of labels to the chart.

However, therein lies the rub. Perhaps it is time to add “because things are getting better” to the label set. It doesn’t have to be all negative events, just things that can challenge valuations or sentiment.

Market momentum

Market momentum is very strong, reflecting exuberance. The graph below is a crude but effective way to capture the following: a stockmarket can only grow in line with the underlying return on equity of the companies within it, and can’t indefinitely sustain itself above that growth rate.

You can either grow the book value of equity by the ROE multiplied by how much you retain or, at the other end, you can retain no earnings, and pay it all out, in which case your return is the dividend yield.

As such, when the market value (the darker line) is above the dashed long run average, which is a proxy for the level of sustainable growth, you should take note.

Risk premia

Equity risk premia are getting to levels that have proved problematic in the past. There’s a lot riding on the “blockbuster growth” narrative, and presumably also the expectation that Biden doesn’t “balanced budget” it out of existence with tax hikes.

E.g. the blockbuster growth is likely going to be paid for by tax rate hikes, meaning that corporates won’t necessarily participate to the full extent of the broader economy (i.e. great for Main Street, maybe not so much Wall Street).

Profit margins

Corporate profits are pretty high. A hot economy, the sort in which a wages Philips curve works and there’s upward pressure on wages, combined with tax hikes, can put a dent in one’s enthusiasm for shares.

Narrative

Which allows us to focus in on Narrative 4 in the table below. However, we are edging closer to the stage where we can add a 5th, by shoehorning Larry Summers into his own category, given his most recent forecast of 1/3rd chance recession, 1/3rd change stagflation, 1/3rd chance a strong economy. Larry calls it “the most irresponsible policy action of the last 40 years”, which is admittedly very striking given that it appears to be exactly his own advice from 2011-2015. No really, in his own words. Still, we are influenced by his views, even if it is much more at the margin than perhaps it once was.

Emerging markets

Returning to the emerging markets component, we note that things are about as good and accommodating as they can get for the EM region up until the last couple months.

Econometrics

And we place considerable faith in our models, which tell us that the EM region underperforms when the US dollar rises. The level of the interest rate also shows up in the table below, with a negative correlation estimate, suggesting that higher rates are a challenge for the emerging markets.

Risk reward

From a longer run perspective, it’s not especially clear that there is a compelling risk reward proposition to a structural long to the EM region, given that there are smoother investment paths readily on offer. Again, this doesn’t mean “no EM”, it just means that if it has had a good run, and if you are considering how to implement an underweight to equities when you’ve already trimmed your developed market exposures, the EM option makes sense.

Composition

We’d also note that for the most part, the EM is a bet on China, and India. Both of these markets have done well and look, to our mind, toppy, with China’s ill-balanced economic issues, and India’s issues with the virus.

Proceeds

For now, we are allocating the proceeds to cash.

We are very interested in narrowing our REIT underweight, and eventually, narrowing our fixed income underweight. However, given we expect higher yields in the short run, allocating to cash strikes us as prudent.

Correlations

In part, this reflects the fact a) returns to fixed income are low but moving higher which could cause short term losses, and b) the correlations to other assets are not as low as they could be.

Dynamically changing correlations are a part of life, and over the long run, we expect a negative correlation between bonds and stocks in the order of about -0.30.

But for now, the case for fixed income is weaker given the higher correlations.