Justin Onuekwusi, manager of the Legal & General Investment Management (LGIM) Multi-Index fund range outlines four alternatives to gold in the post-Brexit environment
As an asset allocation team that takes more of a medium-term investment view, we typically tend to look through short-term macroeconomic and political noise. However, when the short-term risks are significant enough, we act.
Following the UK’s vote to leave the European Union (EU), other global events have continued to capture our attention. Given the various political and economic uncertainties unfolding in Europe, combined with concerns about the Federal Reserve (Fed) increasing rates more quickly than expected and the possibility of a Chinese hard landing, we have reduced our overall risk outlook from neutral to negative.
Today, the opportunities for multi-asset investors extend much further than traditional safe-haven assets such as gold. As the dust settles following the EU referendum, talk of ‘Brexit means Brexit’ will continue.
But the multi-asset universe is laden with opportunities and constantly expanding. It is the role of the investor to adapt and evolve within it. Volatility creates opportunity, and as Peter Lynch once said: “The person that turns over the most rocks wins the game.” This is particularly true for multi-asset investing
Interest rate sensitive sectors
As many anticipated, the Bank of England (BoE) acted aggressively to address post-referendum market volatility and reduced interest rates in August. This benefitted interest rate-sensitive sectors such as hard currency emerging market (EM) debt (EM debt priced in US dollars) and global real estate securities.
A further tailwind comes in the form of ‘lower for longer’ rates, which are likely to exacerbate the demand for yield and reduce the expected cost of debt for these asset classes.
All that shines is not necessarily gold. The price of oil plunged in the immediate aftermath of Brexit, but it has since recovered from its lows. Indeed, we have been seeing upside risks in the oil market, which could start to move back into balance after two years of oversupply.
Rather than a cause for concern, recent falls may prove an opportunity for multi-asset investors to begin increasing their exposure to the energy sector once more. Given the relative weakness of energy-related equities in the last two years, stabilisation in the oil price could lead to significant gains in the sector.
GEMs regaining their sparkle
EM equities have always been one of the more risky asset classes in the multi-asset investment universe, and China’s growing debt remains a cause for concern. But as oil-related sectors gain appeal, so too do the prospects for many EMs linked to oil and mining companies.
Of course, prospects for global emerging markets (GEMs) are also tied to changes in Fed policy. But while a Fed rate hike and Chinese hard landing are clear reasons to be cautious and even underweight EMs, investors may look to benefit from the changing outlook for oil-linked economies by reducing this underweight somewhat.
The UK conundrum
In contrast to 2015, 2016 has proved a challenging year for active UK equity funds: the average manager has underperformed the FTSE All-Share Index by over 4% year-to-date (YTD).
A reason for this has been the strong performance of the FTSE 100, which makes up the largest 100 companies in the FTSE All Share (i.e. large cap companies). Given the huge falls in the value of sterling in 2016, the FTSE 100 has significantly outperformed the FTSE 250 (representing the next largest 250 companies in the FTSE All Share i.e. mid-cap companies) – returning almost 14% versus just over 5%. Amazingly, this would place the FTSE 100 Index in the top decile of the IA All Companies sector year to date.
History shows the average active UK manager underperforms when mid-cap companies suffer significant underperformance. Relative to other developed equity markets the FTSE All-Share is uniquely concentrated. Indeed, the top 10 stocks constitute over 40% of the overall weight of the FTSE All-Share.
To outperform, UK equity managers will typically have to descend the capitalisation spectrum and adopt more mid-cap risk. However, as sterling falls – which it has been doing both pre- and post-EU referendum – larger caps benefit because some 75-80% of their revenues are driven from overseas, versus only around 50% for many mid-caps. If sterling continues to weaken, this trend of underperformance is likely to continue – which would of course benefit an index strategy over active funds.
While many investors have benefitted from a structurally lower weighting to mid-caps in favour of large-caps in 2016, they may want to start increasing their mid-cap exposure again if they believe we are coming to the end of sterling weakness. However, it is important to remain vigilant of the risks, because a weighting to a UK index fund – and specifically, a large cap strategy – could help to hedge any further Brexit uncertainty over the medium term.