Political risks blunt portfolio performance

Events conspired to hurt the tactical asset allocations of our Alpha multi-asset portfolios in October. True, we knew there was a major fiscal event on the horizon with UK Chancellor of the Exchequer Rachel Reeves’s budget, and that the rough and tumble of a savage US election battle was playing out in the background. Still, the TAA model is rules-based protective momentum, so we simply do as it says and must judge its performance over a longer timeframe.

Bad months are to be expected and October certainly fell in that category as stock markets stuttered and the holdings of longer-dated UK government bonds (gilts) proved a drag. In the case of developed market shares, the MSCI World index which is heavily exposed to US mega-cap tech stocks was down -1.96 per cent in the month and our concentrated position in UK large caps via the FTSE 100 pulled back to the tune of -1.45 per cent.

Source: Investors' Chronicle, LSEG, ARC Private Client Indices powered by Suggestus

The biggest loser, at -4.3 per cent, was the emerging markets position. This is volatile thanks to Chinese markets (around 28 per cent of the index) oscillating as investors digest various stimulus packages. The MSCI Emerging Markets is also sensitive to adjustments in sentiment towards the significant valuation risk in markets such as Taiwan (largely a bet on TSMC, the world’s largest semiconductor foundry) and India, which are just shy of 18 and 20 per cent of the index, respectively.

After November rebalancing the portfolios retain sizable positions in the MSCI world, which is a core holding and always makes up the lion's share of our strategies' global shares allocations when the system is not in “crash protection” mode. The emerging markets position is also maintained, as although it did poorly in October, the strong correlation-adjusted momentum when total return performance is analysed over one, three, six and 12 months ensures it still ranks highly.

The FTSE 100 index makes way, however. In the part of our strategic allocations earmarked for global shares, its overall multi-timeframe momentum ranking falls behind that of the MSCI Japan. When it comes to the portion of our portfolios reserved for continual UK exposure, we are pushed toward the UK mid-cap space via the FTSE 250 index.

Source: Investors' Chronicle, LSEG

One valid criticism of the momentum-based methodology is that during times of meandering uncertainty we can trade in and out of satellite positions, and lose by getting bounced out on the pullbacks and buying back-in after a rally has been missed. To an extent, the blend of momentum timeframes should mitigate this risk, but it’s still possible.

The risks to the Japanese and FTSE 250 equity positions for the months ahead are palpable. In Japan, equities rose in October partly due to expectations the yen would weaken after the recent election result. Longer-term, should the Liberal Democratic party’s loss of its majority stifle policymaking then that would be bad for shares. If the market starts to factor this in throughout November (along with an elevated risk-free rate if the Bank of Japan feels it can maintain its plans to normalise to higher interest rates) then we could again see a holding drop out of the TAA frameworks after just one month at a loss.

Britain has its own issues and there is cause to doubt whether the historically more domestic-focused mid-cap index can beat large caps. If the effect of the Labour government’s budget plans is to stifle growth through higher taxes and elevated cost-of capital crowding out private sector investment, it won’t bode well for the prospects of FTSE 250 stocks outperforming.

Changes in cost of capital are to a large extent driven by the market rate of interest, which could remain elevated as gilt investors demand higher compensation for the inflationary risk of state spending. As yields rallied in the last month (meaning bond prices fell) the TAAs took a loss on gilts with longer to go until maturity, as these bond prices are more sensitive to interest rate changes. This dynamic forced gilts with 5-15 year and more than 15-year maturities, as well as the longer duration inflation-linked gilt index, out of the TAA heading into November.

Although sterling-denominated investment grade (IG) corporate bond total returns have been dragged down by the rally in sovereign yields (corporate bond yields must offer a spread over gilts because companies, unlike the government, can’t print money to pay bills and therefore carry a risk of default), the multi-time-period momentum trend is good. In a note of caution, gains in sterling credit are more due to fluctuations in currency markets than because spreads are narrowing in a vote of confidence for UK plc. This could be a further risk for the sterling-denominated corporate bond position in the TAAs which has returned a disappointing -1.18 per cent over the past month.

US dollar-denominated credit positions in the IG and high-yield (HY) spaces are taken on the back of momentum for these asset classes thanks to receding fears of a US recession. Over the past year, demand from investors has outstripped supply as companies have sought to reduce balance sheet risk, which creates a dangerous dynamic that may catch the TAAs out. Blackrock’s Investment Institute (BII) argues spreads offer a slim risk premia, implying US credit isn’t cheap relative to the quality of bond ratings.

Source: Investors' Chronicle, LSEG

Currency is another prominent theme in this month’s reset. In the US bonds portion of our asset allocation the strong momentum behind lesser duration US Treasury Inflation-protected securities (Tips) has seen it take a prominent position in the models. Both the Bank of England and the US Federal Reserve are itching to cut interest rates and neither country is exactly committed to fiscal rectitude, whatever the politicians say. With that in mind, despite election volatility, the dollar may yet be a haven for UK investors given Britain’s weaker economic growth.

US Tips are the crash protection asset of choice for the TAAs this month, although the presence of gold in the portfolios is a nice diversifier despite the yellow metal’s valuation risk, already evidenced by a slight price pull-back at the beginning of November. With this in mind, it’s useful the TAAs all still have a bit of sterling-denominated cash, too.

Source: Investors' Chronicle, LSEG

Unsurprisingly, the drawbacks of using momentum as a mechanical TAA signal are beginning to show as we critique the positions bought into and sold. This highlights the case for diversifying the rules-based TAA across more models as we build it out, although this must be done without undermining the primary benefit of protective momentum which is its propensity to seriously dilute losses in the worst market crashes.

On the subject of other drawbacks, the required number of trades to adjust between October and November is four sells, five buys and then readjustment trades for another five positions.

TAA applied to our November 2024 Moderate Risk strategy