Pioneer group CIO Giordano Lombardo mulls risk in mind of equity market highs and credit spread lows

Giordano Lombardo, group CIO at Pioneer Investments, says in his latest ‘CIO Letter’ that time has come to re-consider allocation to risk assets in mind of equity markets being near all-time highs, while credit spreads are at historical lows.

In the last five years, we have seen an increasing appetite for risky assets. At the beginning, it was a consequence of the search for yield and return enhancement in a low interest rate environment. More recently, it translated into a deeper exploration of yield opportunities in the riskier side of risky assets, featuring high-yield bonds and small-cap
stocks.

Our asset allocation has retained a positive view on risky assets since 2009. Now, with equity markets close to all-time highs and credit spreads to historical lows, we think that we should ask ourselves two questions: first, whether it is still worth being long on risky assets; second, whether the investment approach adopted so far is the most appropriate for meeting investors’ needs and facing the new market challenges.

On the first question, let me say that we believe that a more balanced and diversified portfolio will likely be more appropriate going forward. We have been scaling down risk, although we remain constructive on the underlining scenario. With reference to the second question, our investment process has been constantly evolving in the last few years with a big emphasis on revisiting our portfolio construction and extending risk budgeting methodologies in the activities/capabilities where they can add most value.

The answer to the first question is strictly connected to our base scenario for the global economy and on how the multiple transitions we have discussed in our outlook for 2014, are progressing.

In the US, the economy is at a relatively mature stage of an expansionary cycle as GDP rose well above the pre-crisis level. However, the legacy of the financial crisis remains, as stronger growth has still not been reflected in a sharp increase of personal incomes as was often the case in past upturns. The portion of national income that goes to employees is at multi-year lows, while the same percentage for corporate profits hovers at record highs. Also, the level of long-dated unemployment, as well as the falling workforce participation rate, suggest that a full normalization is still a long way off.

We believe the main risk with US growth lies with monetary policy’s effectiveness going forward: with interest rates close to zero, if something goes wrong (if for example the weak economic figures released early this year were not merely affected by bad weather but were genuinely weak) the FED would have its hands tied for future policy action.

In the Eurozone, despite an improvement of cyclical indicators, we still have unacceptably high levels of unemployment and real GDP is still below pre-crisis levels.  

Here deflation risks are not negligible and monetary policy seems stuck between political constraints (with the opposition of some countries to implement more aggressive and unconventional measures) and a two-speed economy (the core and the periphery of the Eurozone would require a dual monetary policy, clearly unfeasible). Both peripheral and credit spreads have declined by so much that they may be priced for very positive outcomes, whereas European equity still offers an appealing risk/return profile compared
to other developed markets.

China is dealing with reforms, first of all, to redress an economic growth model that is too credit-addicted. Here the political leadership has to quicken the pace of reforms in order to foster a more balanced and sustainable growth in which consumer spending takes the lead. The challenges are huge, but we see positive signals in this respect and we are mildly optimistic that the route taken may bring an orderly adjustment.

Emerging economies, other than China, have seen their contribution to world growth further diminished and a few are going through serious difficulties, sparking concerns that the transition towards a more balanced and slower growth will not be smooth and painless. Trouble spots are surfacing in a growing number of countries in which investors have rediscovered political risk and, above all, macro vulnerability to external deficit and fiscal profligacy (Venezuela, Ukraine, Thailand, partly Turkey, are the most relevant cases in point).

The above-mentioned scenario and the stretched valuations in many risky assets, as a result of the long-lasting search for yield brings, in our view, two major implications for investments: first, expected real returns are lower on the time horizon of a strategic asset allocation, compared to recent trends, for most of asset classes; then, risks associated to extreme (“tail”) events are increasing.

So, while we felt it was appropriate to take a decisive long exposure to risky assets until last year, now we believe that building more balanced and diversified portfolios would be a better strategic choice for the scenario unfolding.

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