Investment - Articles - 2012: Asset Classes and Key Drivers

 By Steven Yang Yu, Dan Mikulskis, Gurjit Dehl & Jonathan Letham at Redington
 As we enter 2013, the Year of the Snake, let’s review the Year of the Dragon by looking at how major asset classes have performed and the key drivers behind the moves. Note: all 2012 asset class returns quoted in this article are to 30 November 2012, data source for all returns is Bloomberg unless otherwise stated, calculations by Redington.
 UK Inflation
 Long-term inflation expectations fell – 30 year breakeven inflation (as measured by the zero-coupon RPI swap curve) is currently around 3.25%, this compares with 3.4% at the start of the year and recent highs of around 4% in 2008. Long-term real yields rose, moving from negative territory in December 2011 to slightly positive today.
 A number of factors were behind this move lower, although the inflation outlook remains uncertain. The Consumer Prices Advisory Committee (CPAC), which advises the National Statistician on inflation matters, announced it is working to “identify, understand and eliminate unjustified causes of the formula effect gap between the CPI and RPI.” UK growth remained subdued, as highlighted by the OBR’s -0.1% forecast for GDP in 2012 announced in the Autumn Statement. Wages and retail sales have failed to keep up with rates of inflation, keeping the economy in the doldrums.
 The CPAC issue is expected to be resolved during the coming year, until there is a final decision we expect to see volatility in the breakeven inflation markets.
 UK Interest Rates
 The lack of UK growth did not deter investors from buying UK government bonds. We saw a sharp fall in 10 year rates, over twenty basis points lower than a year ago, but 30 year rates remain close to where they finished in 2011. There were ups and downs along the way, with the 30 year yield moving in a range of 2.85-3.49%, highlighting the benefits to a scheme of being hedged with respect to these exposures.
 Global Government Bonds
 The crisis in the Eurozone seems to be relieved rather than resolved, making the UK a relative safe-haven from the turmoil abroad. With elections over, the US is staring at a fiscal cliff. And, the Bank of England announced a £50bn increase to their asset purchases in July, bringing the total to £375bn (over 30% of outstanding public debt).
 Globally government bonds continued to fall into two categories: “safe haven” markets or the increasingly more risky markets associated with the European Periphery. Another influence on these markets continued to be the extent of monetary easing policies undertaken in the local market. Spanish and Italian bonds continue to remain in the more risky European peripheral camp in 2012 with yields on their generic 10 year issues around the 5% mark, although Italy’s bonds did rally in price terms over 2012 with the generic 10 year yield down from the highs of 7% at end of 2011. US, UK and Germany continue to be seen as safe havens with yields on generic 10 year issues further decreasing. The UK yield has fallen from 2% to 1.8%, the US from 1.9% to 1.6% and the German yield has dropped from 1.9% to 1.4% over the course of 2012.
 Equity market returns over 2012 were above long term averages in most major markets, although there was some divergence between different markets. As of 30 November 2012 the FTSE 100 is back to levels seen at the end of 2010 with a total return of 7% so far in 2012. This compares with a total return of -2% in 2011, 11% in 2010 and an average over the last 5 years of 2%. On a global basis the FTSE 100 was not one of the top performing major equity markets over 2012. The S&P 500 and DAX both outperformed the FTSE over 2012 with total returns of 15% and 22% in local currency respectively. The MSCI World Index as whole has returned 14% in 2012 (in local currency terms) whilst the MSCI Emerging Markets index shows a return of 13% (in USD terms). Overall there was not much difference between Developed and Emerging equity in 2012.
 Generally speaking realized volatility in equity markets was a little lower than it has been in the recent past, although admittedly recent years have seen much higher levels of volatility than has historically been the case. The realized volatility of the FTSE 100 total return index (measured as annualized standard deviation of daily log price changes) was 15% in 2012, compared to 21% and 17% in 2011 and 2010 respectively. By comparison the realized volatility of the S&P 500 and DAX indices were 13% and 19% respectively for 2012.
 The market pricing of options to hedge against equity market falls reflected the slightly lower levels of volatility. In 2012, the VIX volatility index (which represents the implied volatility on short term S&P 500 options) has fallen c6 volatility points from 23 at the end of 2011 to 17 at the end of November 2012. Overall the VIX level has been on the decline since the recent highs of 43 in August of 2011, although there was an intra-year spike to a level of 27 in May 2012.
 One trend we have seen over the course of 2012 is increased demand for equity mandates that seek to deliver a lower volatility than the market-capitalization weighted indices. In our experience there are two ways of implementing this: Volatility Control at an aggregate level by de-gearing the level of exposure, and a Low Volatility Stocks approach which seeks to select the least volatile stocks in the index and/or weight these inversely to their level of volatility as opposed to their market capitalization. Many product and index providers have launched products in these areas and we expect to see this continue.
 The three broad classes of credit all performed strongly, with spreads tightening. UK Investment Grade credit saw a return in excess of swaps of 7% to 30 November 2012, compared to returns of 4% and 1% in the previous two years. Subordinated Debt is up 30% and European High Yield debt up 25% over the year to 30 November. At the time of writing spreads on High Yield are at c540 basis points, well below the levels seen at the end of 2011 of 780, and the highs of 1500 in 2008-9.
 Given the historically low level of credit spreads we have seen an increasing desire on behalf of pension funds to manage their credit exposure on a “Go anywhere” mandate where the manger has discretion to dynamically allocate between Investment Grade, High Yield and Subordinated bonds.
 It has been a mixed bag for commodities in 2012. Crude oil prices are almost 10% lower, cotton prices are over 20% lower and coffee prices have dropped 35% from a year ago. Meanwhile, corn, cocoa, soybeans and wheat all recorded double-digit price rises. Gold, revered by some investors as protection against monetary easing, did not surpass its 2011 high above $1,800/oz and is currently 5% higher than last year’s closing price. Overall, commodity price indices are very close to where they finished in 2011.
 Building a diverse portfolio of exposures
 As always the need to build a properly risk-managed diverse portfolio of asset classes remains as pertinent as ever. We have also seen an increasing interest on behalf of pension funds to look at their exposures to different asset classes through the lens of risk exposure as opposed to fixed market exposures. This has motivated an increasing look at the family of Risk Parity strategies, for which various providers have been running mandates for some years – albeit with significant methodological difference between providers, particularly since 2009.
 Steven Yang Yu, Director of ALM & Investment Strategy
 Dan Mikulskis, Director, ALM & Investment Strategy
 Gurjit Dehl, Vice-President, Education & Research
 Jonathan Letham, Analyst in ALM & Investment Strategy

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