Monday, March 5th, 2012

Multi Asset Model Commentary 05/03/2012

(This commentary was written originally specifically for the US Dollar Multi-Asset Model)

Market conditions

Equity markets have had a strong start to the year, with emerging markets leading the way in terms of the YTD numbers. This is partly because their rally began in January, whereas the US started in December. The most important point about the equity rally so far is that government bonds have not fallen in response.

For the time being, they remain even more overbought than equities. The narrative behind the rally has two main themes: (1) a gradual recovery the real economy in the US constrained by deleveraging in the financial sector and (2) financial disaster averted in the Eurozone at the expense of further damage to long term growth rates and political fabric of the peripheral countries. Rising oil prices remain a concern, but would benefit some emerging markets.

Current positions

Government and corporate bonds still account for over 50% of the portfolio, with US REITS having the highest weight amongst risk assets. The rally in REITS began earlier than US equities and their higher yield is also attractive to many income-starved investors. Most of the underlying assets are in commercial rather than residential property and are therefore not affected by the ongoing problems of the US housing market.

For bonds investors who are concerned about inflation real estate represents a valuable hedge, because it is very hard to imagine a a scenario in which prime commercial rents would not more or less match rising inflation rates, probably to the detriment of profitability in the US corporate sector.

Outlook

The diagnostics, which are part of the PRATER process, suggest that US equities may travel sideways relative to government bonds for the new few weeks. We think it would take a correction of at least 10% to abort the current rally. Although this cannot be ruled out, we think markets would quickly look forward to a new injection of liquidity from the Fed.

We also note that the portfolio is beginning to rebuild its weight in emerging market equities, which have traditionally been the highest contributor to performance. Provided there is no big sell-off in the second quarter, we would expect to see emerging markets become the asset with the highest weighting sometime in the second half. But this cannot happen without a stable US backdrop.

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