Strategy Update - 15 July 2011
Tristan Hanson, Head of Asset Allocation
Our previous Strategy Update on 13 June expressed a bullish view towards risk assets based on an expected alleviation of growth concerns over the coming months.
Our baseline view has not changed dramatically, but a new twist has been the recent contagion to Italian sovereign debt which, in our view, has made the investment backdrop riskier. Accordingly, we again scaled back equity exposure early this week.
The European sovereign debt crisis has been a recurrent concern over the past 18 months. During this time we have been of the view that a crisis contained to smaller peripheral countries - Greece, Ireland and Portugal - would be manageable at the overall EU level. So far this has proven the case with a series of short-term policy fixes generating an unhealthy, but so far barable, 'muddle-through' scenario.
However, the recent contagion to Italy has the potential to be a very serious development. Italy poses a systematic risk given its position as the world's third largest sovereign debt market. In the week to the 11th July, the Italian 10-year bond yield increased 77 basis points to 5.68%.
The fiscal situation in Italy has not suddenly veered out of control and does look less precarious than in other peripheral countries on several measures: the debt maturity is longer and the primary budget balance is projected to be in surplus in 2011. However, Italy does have the largest stock of debt relative to GDP (120%) behind Greece (158%). Current fears could subside as quickly as they rose up; but once sovereigns are under attack, a self-fulfilling panic cannot be ruled out before the authorities are forced into more comprehensive action. In this sense, the current situation represents something of an unstable equilibrium..
With equity markets (ex EU periphery, where we have minimal exposures across our funds) higher than a month ago when we increased weightings, since which time the situation in Europe has deteriorated (judging by developments in Italy), we thought it prudent to reduce equity exposure given the heightened risk of a market correction. For the time being, a cautious and flexible approach is warranted.
Should we feel the situation in Europe to have eased sufficiently or prices present a much better risk-reward opportunity then we will revisit our position.