Balanced portfolio

The improvement in our overall equities signal has prompted us to increase our allocation in this asset class by 5%. In contrast, we have reduced our bond allocation by 1% following the rally in this market.

Our asset allocation is 55% equities and 51% bonds, compared with a benchmark split of 50% equities and 50% bonds.

Bond portfolio

We are still relatively upbeat on government bonds. Inflation has risen because of base effects but is likely to remain tame. Monetary policies remain highly accommodating and rate hikes will be delayed in the USA and the euro zone until late 2010 or early 2011. These factors can be expected to support bond prices. Massive government debt and the gradual removal of unconventional policy measures by central banks could limit their appreciation potential, however.

We continue to recommend country allocation strategies and positions in bonds that still offer opportunities.

Equity Portfolio

Budget problems in some euro zone countries have unnerved world stock markets, and the capitalisation-weighted MSCI World retreated 2.9% in euro terms in January.

This change in sentiment throws the spotlight on sovereign risk and explains year-to-date share price corrections of 20% in Greece and 15% in Spain.

Avoiding the speculation around the risks of contagion and the disintegration of the euro zone, we are focusing the opportunities being created by excessive corrections. In our view, the real question is the state of public finances and its indirect effect on austerity policies rather than any marked deterioration in corporate fundamentals. After all, companies have learned to diversify their income sources into regions that are still posting rapid growth.

Based on these considerations, we have gradually increased our equities exposure to 105%. We have also moved back into smaller countries that were punished severely during the correction.

Currencies

Both the dollar and, especially, the yen have appreciated on fears of tighter monetary policies in China, announcements of new financial regulations in the USA and somewhat disappointing economic data. The two currencies are considered ‘defensive’. The dollar is up around 1.6% on average against other OECD currencies and the yen is up 2.7% against the greenback.
The euro underperformed all other OECD currencies in January, easing 3.1% against the dollar in the process. This weakness reflected worsening public finances in Europe and investor jitters over Greece.
In contrast, sterling held up well, easing just 0.8% against the dollar. It benefited from improvements among indicators such as industrial production, retailing surveys and employment and BoE comments on the success of the quantitative easing policy.
The Swiss franc depreciated 1.9% against the dollar, which was about average for OECD currencies.

Our valuation models urge caution on the dollar. Despite significant undervaluation relative to the economic fundamentals, its carry against other OECD currencies is unhelpful. Our long-term signal on the yen is extremely positive against the dollar. Still on a long-term view, the pound and Swiss franc remain undervalued against the euro with respect to the economic fundamentals.
Note that in an environment of persistently low risk aversion our models continue to favour highyield dollar bloc currencies dollar against European currencies. They benefit from attractive carry that is likely to improve further.