Still a strong case for defence

Without more economic signals of an end to the downturn, risk aversion is still high among AFI panellists who say that confidence in banks is key to a prolonged recovery in equities.

Despite tentative signs of optimism creeping into this month’s Merrill Lynch Fund Manager Survey, the Adviser Fund Index (AFI) panellists are not ready to abandon their defensive positioning.

Of the 212 respondents to the Merrill Lynch Global Survey of managers only a net 6% saw the global economy weakening further over the next 12 months, against a net 24% in January.

Most of this change was because of improved sentiment towards China and America which both saw less negativity towards their growth prospects.

However, the shift in outlook was not reflected in a move of asset allocation with a net 34% of managers retaining their sharp underweight in equities. This was a steeper underweight than that recorded last month.

Like the respondents to the Merrill survey, the AFI panellists have yet to see enough economic signals of a recovery to start shifting their portfolios to a more aggressive stance.

“I think [if we were rebalancing] what you would find is that there wouldn’t be many changes,” says Ben Willis, the head of research at Whitechurch Securities. “If we were to do it today you would actually see an increase in risk
aversion, with money going into products like corporate bond funds.”

Substantial falls in equity markets across the globe have left stocks trading at historically low valuations. Despite this, continued negative macroeconomic data means investors are unwilling to pile back into equities as pressure remains on earnings and bankruptcy risk stays prominent.

Tim Cockerill, the head of research at Rowan, says while equity markets have enjoyed rallies, since the onset of the
crisis these have proven short-lived bear market bounces.

“On the current outlook I would remain defensive,” says Cockerill. “In these markets there are short periods where optimism seems to be justified. If you take a step back, however, I think I would want to stay defensive in anticipation of more bad news to come.”

Since the beginning of February the FTSE 100 index fell by 6.58% to February 23. Recent falls pushed the index back under 4000, underlining that volatility remains in equity trading and it is still uncertain whether the bottom of the market has been reached.

“I would like to see the markets looking better in the longer term, which we’re not seeing yet,” says Cockerill. “I feel we’re going to see increasing numbers of redundancies and more companies going bust. To really see something changing you need to see positives across numerous indicators and not just for one month, but for two or three.”

Consensus in the market appears to suggest, therefore, that things could still get worse on a macroeconomic level before they get better. In this environment buying equities will remain a short-term play to take advantage of small
rallies in certain sectors.

The Merrill Lynch survey showed that manager sentiment towards banks remains resolutely negative as their heavy underweight stayed constant over the month. Gary Baker, the head of EMEA Equity Strategy Group at Banc of America-Merrill Lynch, says confidence in the banking sector will be key to a prolonged equity recovery.

“It seems very difficult to envisage any sustained equity rally unless you see better sentiment coming through on banks,” says Baker.

With the news that the American government may increase its stake in Citigroup to as much as 40%, troubles in the banking sector seem far from having abated. The problem-ridden merger of Lloyds TSB and HBOS has also been a cause for concern for investors.

“I think February might be quite telling as I suspect things will get worse,” says Cockerill. “The one thing that could change that would be if the banks were nationalised. This would effectively draw a line under the bad debt on their balance sheets, and I actually think we’re getting closer to that happening.”

Although there is little appetite from AFI panellists to add equity exposure in their portfolios, advisers are unlikely to crystalise their losses by selling the equities they hold at current prices. While risk aversion remains a key motivation behind current portfolio construction, the risk position of the portfolios has changed little since the end of last year.

Willis says, however, that one of the earliest signs of a recovery will not be seen in the equity market.

“If you already had exposure to equities you might keep it but you certainly wouldn’t increase it,” he says. “The bond markets need to improve first with investment grade bonds seeing improvement before high yield becomes attractive.”

With bond markets currently pricing in severe default risk, some investors are finding the risk/reward profile of investment grade fixed income a compelling opportunity.

“The potential returns from investment grade corporate debt are really interesting at the moment,” says Willis. “I think the market is pricing in defaults of 40% over the next five years but they’re unlikely to go much higher than 2%, so you’re being paid to take on that risk.”

AFI performance over one year

The Adviser Fund Index series – a summary

The Adviser Fund Index series comprises an Aggressive, Balanced and Cautious index each tracking the performance of portfolio recommendations from a panel of 18 investment advisers. For each risk profile, all panellists specify a weighted portfolio of up to 10 funds from the authorised UK unit trust and Oeic universe that, when aggregated, define the constituents and weightings of the three AFIs.