Over the last year, we have gone through a root-and-branch review of our investment process. Whilst the majority of items just required some fine tuning, a couple of other changes are more significant and worth explaining in further detail. First-up is the way our regional allocations within growth assets are comprised.
Your attitude to risk governs which risk profile is appropriate for you. Meanwhile, the target portfolio allocations we build aim to deliver outcomes appropriate for each risk profile. Once each of these is known, your investment manager builds your portfolio around the appropriate target allocations.
Shown in the chart below is a breakdown of growth assets by regional equity market. We can see a good level of diversification across all risk profiles, but on closer inspection you will notice the level of UK equities represents a higher proportion in lower risk profiles while being a lower proportion in higher risk profiles. The rationale for this breakdown has been to manage the risk of foreign currency holdings in portfolios, especially those with lower risk tolerance. However, we think the time is right to change this.
China accession to the World Trade Organisation in December 2001 marked the beginning of what we now refer to as ‘globalisation’. Over the last 20 years, companies all over the world have been able to outsource their manufacturing requirements to China and benefit from its lower labour costs. Global sourcing of products has, until recently, required large scale operations. Businesses have needed whole departments to manage procurement, logistics, shipping etc. The scale of big business really did go global.
With its earnings from increased trade with the rest of the world, China reinvested internally on a massive scale, building new cities, roads, rail networks, bridges and telecommunications infrastructure. All this investment has been especially beneficial to companies that produce physical commodities and energy. In particular, the UK equity market enjoyed a great combination of a mix of large companies benefiting from globalisation as well as companies selling commodities.
We believe the trend of both globalisation and massive Chinese infrastructure investment are unlikely to continue and may even possibly reverse. Whilst there are numerous reasons for this, the key drivers are:
- Technology innovation: by its nature, technology transforms what has hitherto been possible. The most recent wave of technology innovation has spread beyond the technology sector. Technology enabled businesses have connected directly with consumers through their smartphones, which has led to new business models, many of which have disrupted industry incumbents in record time. The next innovations in technology promise to be equally disruptive across even more economic sectors.
- Trade-wars: we have written extensively about the trade-war between the US and China. It is difficult to have certainty about how things will play out exactly, but it seems likely there will be less economic and technological integration between them. We think there is a good chance their spheres of technological influence are likely to diverge.
- China’s evolution: the model of economic growth for China had focused on large infrastructure projects and being the manufacturing hub for the world. The result was rising Chinese income levels to the point where today, China no longer has a low-cost work force. Consequently, the model of economic growth began shifting a few years ago, towards fostering a stronger, internally driven consumer economy. We think the trade-war cements China’s ambition to safeguard this transition and so future economic policy is unlikely to foster the same patterns as the past.
For the reasons set out above, we believe it is important to adjust our regional allocations to better capture these changes and opportunities. The chart below shows the exposure to different sectors that one gets when investing in different regional markets. There are significant differences, most starkly so with the exposure to technology and communications sectors vs materials & energy sectors (commodities), between the US and Asia versus the UK.
Consequences of change
We have investigated the potential consequences of reducing our allocation to UK equities in favour of other regions. The charts below show the difference in total return and portfolio risk of alternative UK allocations (UK @ 30% and UK @ 20%). Through over 30 years of market history, in aggregate we observe higher total returns which more than compensates for the slight increase in overall portfolio volatility. Of course, this is backward rather than forward looking.
We acknowledge there are risks facing the technology, energy and materials sectors going forward, most notably from the potential increase in regulation and taxes. Despite these concerns, we believe the technology sector is in a strong upward trend, while the energy and materials sectors are structurally challenged for growth.
Meanwhile, we also recognise the UK equity market is under-loved and under-owned given all the uncertainties created by Brexit.
It is for all these reasons we choose to take a phased approach to the change.
What to expect
We have begun to reduce our investment in large UK companies from around 40% of your equity exposure to around 30%. We think this part of the market is least exposed to possible upside related to a favourable Brexit outcome. In its place you will find a combination of global and emerging market (Asian) equity exposure.
Over the course of the next 12-18 months we will further reduce the allocation to UK companies to 20% of your equity exposure. The resulting portfolio mix will be more geographically diversified and allow us to best capture the long-term structural trends that we see driving economies and markets over the long term.
We believe that by adjusting regional allocations, we can build more growth orientated portfolios that address the structural changes occurring in the global economy.
We are excited about further enhancements in the future and we look forward to updating you on these in due course.
Have a question about investing with EQ? Please email firstname.lastname@example.org or call 020 7488 7171, we’re always happy to hear from you.