The sovereign bond market is about to enter a difficult period in the developed world. The Fed and the ECB's desire to scale back their monetary support, the possibility of fiscal policy adjustments in the United States and Europe, the stabilisation of the global economy and the slight rise in global inflation - despite the Bank of Japan going all-in - mean we have to seriously consider the possibility of a change in the economic and monetary balance. Moreover, the political agenda is particularly busy, with the US election at the beginning of November, Italy's constitutional referendum in December, and French and German general elections in 2017. Each of these public votes presents an opportunity for nationalist parties to push an alternative economic policy based on fiscal expansionism and in some cases less open borders.
This combination of destabilising political and economic factors naturally leads us towards a rather defensive positioning.
Our exposure to equity markets is partially hedged with short futures positions in the indices of countries that look most vulnerable to shocks. We have strengthened our energy investments to give the portfolio more exposure to a theme capable of performing well during periods of economic recovery. At the same time, we have slightly reduced the weighting of high visibility companies that are more sensitive to rising interest rates. The rate at which government bond yields rise will be decisive for equity market performance. Equities could withstand a controlled increase if this came with expectations of an economic recovery, and not just in response to monetary normalisation and widening budget deficits.
On the bond front, caution remains the watchword. Many sources of opportunity remain but we have significantly reduced the duration of our investments. All in all, we see little value in the government bonds of developed countries. The real opportunities are to be found in the emerging world, due to disinflation and improving currency account balances.
The foreign exchange market is also brimming with opportunity. The euro's steadiness against the dollar due to different forces cancelling each other out contrasts with the pound's structural weakness and the constant appreciation of many emerging market currencies. We prefer to remain underexposed to the dollar in these particularly uncertain times, as we focus on delivering absolute returns. We also question the yen's hitherto unfailing ability to benefit from risk aversion, now that Japanese monetary policy looks set to weigh on the yen.
Worldwide, we are expecting fresh volatility, which could mark the start of a massive reallocation of bond investments to equities once the heaviest uncertainties have eased. Whereas the prospect of fiscal stimulus would reassure the equity market, it would destabilise bond markets if monetary support were to be withdrawn too quickly.
Source of data: Carmignac, CEIC, 30/09/2016