During our previous Asset Allocation Committee meeting we expressed a desire to further diversify our exposure to credit securities within our portfolios. This view was driven by the significant pull back in credit markets in March, which Lonsec believes provided an opportunity to enter certain parts of the credit market, such as syndicated loans, which were previously considered fully valued.
This view has since been implemented within Lonsec’s Multi-Asset and Retirement Managed Portfolios. The allocation further diversifies the portfolios away from duration risk (interest rate risk associated with government bonds), and diversifies the sources of income, most notably within the Retirement Managed Portfolios, which have been impacted by the deferral and reduction in company dividends within the equities component of the portfolios.
In our most recent Asset Allocation Committee we have not made any changes to the existing asset allocation settings. The previous move to neutralize our slightly underweight exposure to equities has benefited the portfolios as equity markets have continued to rise on the view that COVID-19 cases have peaked across many key economic regions, and that economies will begin reopening for business. At the same time, the market has reacted favourably to further fiscal stimulus packages announced in Europe and China.
The output from our asset allocation model has not changed materially since our previous meeting. Some notable changes, however, include the reduction in valuation opportunities within equities, given that share markets, most notably in the US, have recovered since their trough in March. Our valuation model indicates that most asset classes are trading at fair value, with the exception of government bonds, which continue to look expensive, and A-REITs, which look attractive on a relative basis.
Liquidity and policy remain favourable as central banks and governments continue to prop up economies via monetary and fiscal easing measures. Cyclical indicators reman weak, with most economic indicators such as unemployment figures and PMIs continuing to show weakness. Finally, risk indicators such as the VIX and MOVE indices continue to trend down. Indeed, the MOVE index, which measures implied volatility within bond markets, has returned to pre COVID-19 levels.
While markets have shown strength, risks remain. The impact of COVID-19 on company earnings remains unclear at this stage, while the market has been pricing in negative news, meaning any news regarding company earnings that is worse than expected will likely adversely impact markets. Geopolitical risks, while ever present, are in the spotlight again. Tensions between the US and China are elevated, and the path forward is unclear. This is against the backdrop of the upcoming US election in November and recent civil unrest within the US following the death of George Floyd at the hands of US police.
Finally, if we try to look ahead, one of the risks the market is not factoring in is inflation. While our view is that inflation is not a risk in the near term, possible structural shifts to the make up of economies on the back of COVID -19, specifically the potential decline in globalization, changes in supply chains, and the re-emergence of manufacturing industries in service-based dominated economies, may see prices of goods and service increase in the future.
In the shorter term, should we see the ‘V’-shaped economic recovery, the risk of inflation is a plausible scenario given the magnitude of stimulus we have seen in recent months. Within our portfolios, we do have exposure to assets that can offer some inflation protection, notably via infrastructure and gold exposures.