Sterling being pro-cyclical means it tends to rise when the wider economic climate is positive, and fall when it is negative.
Of course, the US can also be the source of political risks, but in contrast to other currencies, the US dollar often rises when the US is the source of political risk, as investors seek a haven in the global reserve currency. Consequently, in the absence of a strong currency view, holding US or Japanese equities on an unhedged basis should probably be the default for most sterling-based investors.
The dollar is therefore another example of an asset that rises in value when equities are potentially falling sharply.
Finally, from an asset allocation perspective, there is a tactical argument for holding a higher-than-usual cash weighting. Although elevated cash weightings are a drag on portfolio returns over the long term, they can be useful over the short term, especially following a period of strong equity returns and uncertainty over inflation and interest rates.
Diversification within asset classes
How a portfolio obtains its exposure to an asset class can also offer an important source of diversification, particularly in equities, where historical style and factor behaviours are fairly well defined. Within equities, value styles may offer protection against higher inflation and interest rate regimes, and can be implemented either actively or passively across sectors, to help avoid excessive weightings in the ‘typical’ value areas such as energy and financials.
Value strategies usually require economic growth to remain on track. However, strategic asset allocations will inevitably encounter cyclical downturns, hence balancing other factor exposures is important. While some high-growth areas carry valuation risk at present, we have seen that more established and profitable growth businesses with strong balance sheets can also offer defensive characteristics, given their essential role in modern societies. Hence an allocation to quality growth can help diversify and balance equity exposures.
Thematic equities can also play a role. Again, care needs to be taken as some high-growth themes come with valuation risk and the risk that strong investor enthusiasm fades. But carefully selected themes can offer exposure to a combination of secular growth as well as cyclical exposure, rather than a client having to effectively choose one or the other, which is often what happens when clients try to take an approach based on shorter-term considerations.
Thematic equities do not have to be focused on higher-growth areas. For example, listed infrastructure can provide a more defensive equity exposure, sometimes while providing exposure to very niche themes, although inevitably listed infrastructure will bring more volatility than direct infrastructure exposures. This is because, by investing in infrastructure trusts that are listed on the stock market, an investor is taking equity risk, ie. while the infrastructure asset itself is not as volatile as equities, but because the fund which owns the infrastructure assets is itself listed on a stock exchange, the share price on a daily basis of the investment will vary alongside wider equity markets.
