Global investing: Cash and diversified equities best in volatile conditions

M&G Investments

While there are still attractive investment opportunities in global markets these days, careful diversification and more active management and intervention are needed to get the best results in an offshore portfolio, due to the relatively expensive valuations and higher volatility now prevailing, according to Eric Lonergan, portfolio manager for multi-asset and macro funds at M&G Investments (UK). Speaking at the launch of the M&G Investments brand in Cape Town (previously Prudential Investment Managers), Lonergan said that the global investment manager currently prefers cash and diversified global equities in their asset allocation, while global bonds remain expensive across most maturities and investors are paying up (or even losing money) for their diversification and duration benefits.  

Is higher inflation here to stay? 

Weighing in on the current debate around “transitory” versus longer-lasting higher inflation around the world, Lonergan said that investors can’t conclude that higher inflation will necessarily become a more permanent feature of national economies, and result in much higher interest rates and future stagflation as some are forecasting. “The Covid pandemic saw unprecedented and unplanned shutdowns across national services sectors and manufacturing. Producers postponed investment in expanding their capacity, and instead cut costs. Supply chains have consequently had difficulties gearing back up to meet consumer demand, which has jumped amid the re-opening of economies, in turn causing supply bottlenecks and rising prices. The extremes of the economic downturn, and its following rapid rebound, mean that we can’t predict when supply and demand will re-balance across different sectors. Pricing mechanisms still need to fully adjust – in our view, it’s premature to say whether or not we have an inflation problem.” 

He also observed that predictions of longer-lasting higher inflation ignored the fact that global growth was being driven by several structural engines, including the recoveries in three main regions: the US, Europe and China. All of these were proceeding at different speeds, and it was impossible to determine how their combination would impact the overall rates of global growth and inflation over the nearer-term. The US recovery had been steady, with bouts of financial market instability, while the EU had registered permanently weak growth, combined with periodic financial stress coming from the peripheral economies (like Greece and Italy) in the absence of central bank support. Finally, China’s economic cycle was much further advanced, having already fully recovered from the Covid downturn and now slowing in response to policy tightening.  

“We can’t know how these dynamics will play out, so we believe it’s best not to be wedded to an inflation view,” said Lonergan. “After all, having a view on inflation, whether positioned long or short in developed market bonds, hasn’t helped portfolio managers add to returns in recent times given the historically low bond yields.”   

However, he did acknowledge that the global rate hiking cycle had begun, with several developed countries having started raising interest rates – but notably several were in response to factors other than inflationary pressures. This included Scandinavia, where central banks had recognized that interest rate levels were abnormally low historically, and the Czech Republic, where rate hikes were motivated by the economy’s particularly rapid recovery.  

Positioned for higher returns with cash, equities 

Using prevailing valuations as the foundation for M&G Investments’ global asset class positioning, current market conditions meant that the group favours cash, plus equities (as the best source of returns), the latter well diversified and not concentrated in any particular sector or geography. Developed market bonds are expensive and generally to be avoided, only being useful for diversification purposes.  

In bonds, Lonergan noted that shorter-dated developed market bonds are still very unattractive — among the most expensive assets to hold – and that longer-dated bonds had become more expensive over the past year as government yield curves had flattened. Therefore, to get the benefits of portfolio diversification through bond holdings, investors had to pay up. However, M&G Investments had identified more attractive opportunities elsewhere: in emerging market government bonds such as Chile, that would add value to portfolios over the medium term, for example. At the same time, he said, episodes of bond market volatility and mis-pricing had increased significantly, especially since the onset of the Covid pandemic, making it advantageous to adopt a more active (or interventionist) tactical asset management approach to get added alpha from the asset class. “This means we have been taking advantage of mis-pricing more frequently, buying and selling assets more quickly to add alpha to client portfolios,” he explained. Having cash on hand for flexibility in tactical asset allocation (TAA) was important in executing this strategy, he added.  

As for global equities, M&G Investments considers the MSCI All Country World Index (ACWI) to be “reasonably priced” from a historical perspective. With valuations trading around fair value, their portfolios are positioned broadly neutrally from an asset allocation perspective, he revealed.  Within the asset class, however, investors need to be well diversified and selective in their equity holdings, Lonergan cautioned. This is due largely to the wider divergence across company earnings, sectors, and national policies, and different growth prospects around the world. It is also as a result of increased equity market volatility.    

While certain global equities are offering excellent return potential compared to bonds and cash, others could represent value traps, he added. For example, when the share prices of Tencent and other Chinese tech companies plunged in response to news of additional Chinese government regulation earlier this year, it had been a good opportunity to add to Tencent holdings because of the company’s diversification and underlying resilience in its earnings. Yet one has to know when to avoid a stock despite its cheapness as well, and have a very clear idea of what you consider to be fair value for a company.   

So in conclusion, Lategan said we are currently at a very unusual juncture in global financial markets, with the impact of the Covid shutdowns, combined with more nationalist policies, leading to significant divergence across economic growth and asset prices around the world. Episodes of volatility are also more frequent and severe. This has led M&G Investments to be especially well diversified in their equity exposure, and to be holding more cash than usual to capitalise on sudden asset price swings. Finally, but just as importantly, global developed bonds are best avoided. M&G Investments believes that being more interventionist, and also taking on more and smaller bets in portfolios, are among the best responses to market conditions amid the global recovery from the Covid crisis. 

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