The calm after the storm

by Valentijn van Nieuwenhuijzen, NN Investment Partners

During the first months of the year, investors were plain sailing, helped by easy monetary policy, robust economic data and stronger currencies. In euro terms, almost all asset classes generated positive returns. But before the summer had even really started, a strong headwind got up as Grexit scenarios were taken off the shelf and Chinese stocks declined more than 30 percent within a few weeks. As we are not big thrill seekers, we decided to stay close to the coast and reduced our exposure to risky assets. Equities and real estate were reduced to a neutral position and within equities we removed our preference for the eurozone. On both issues, hitting the iceberg has been avoided. Europe agreed to negotiate a new bailout for Greece and the Chinese government took drastic measures to stabilise the Chinese A-share market.

This is not to say that blue skies have returned. Greece still has a long, bumpy road to go, but at least it may no longer make daily headlines in the coming months. China, in turn, will have to regain credibility with international investors, as recent measures were not a good example of a liberalised market with free movement of capital.

Roughly 20 percent of the Chinese A-shares are still suspended from trading and a swift inclusion of A-shares in the MSCI Index seems to be out of reach for now. This is occurring at a time of continued downward revisions of the Chinese growth outlook and a significant debt overhang. Plans to convert debt into equity are to be shelved for the time being.

However, as we are – at least temporarily – back in calmer waters, we decided to bring our tactical allocation to government bonds, equities and real estate back in line with the positive signals from our model. As a result, we are overweight equities again. Positive drivers are the cyclical momentum, valuation and an improvement in price momentum.

Next to that, we do not observe over-optimism among investors; the bull/bear ratio is low. In line with equities, we moved real estate to a small overweight. Fundamentals remain supportive, with the improvement in the labour markets in the US, Europe and Japan as an important driver.

Even the Chinese property market is showing some signs of stabilisation. Not only fundamentals are supportive, real estate also benefits from a yield premium: dividend yields of real estate stocks are on average about 200 basis points higher than corporate bond yields, almost double the long-term average. The biggest short-term risk is a rate hike in the US, which in our view is still insufficiently priced into the US bond market.

The risk of a new, rapid rise in German 10-year government bond yields declined. The drop in commodity prices and low wage pressures limit inflation expectations. Global monetary policy remains accommodative. Finally, price momentum in government bonds has improved. Despite the stabilisation in Greece and China, we did not see any upward pressure on bond yields, which makes us wonder whether there are other, less visible forces at work. As a consequence, we have upgraded our government bond positioning from a small underweight to neutral.

The changes over the past weeks illustrate the basics of our tactical asset allocation. We do not blindly follow our navigation system, but adapt if unexpected risks or opportunities suddenly emerge. We have a flexible, dynamic approach: if facts change, we do not hesitate to swiftly adapt our positioning to the new reality.