Conviction is growing that a recovery is underway and equities have pushed further into new territory for the year.
Among the strongest equity classes are emerging markets which, powered by a strong economic recovery, have led the pack. I am overweight emerging market equities and do not share some people’s immediate concern that the asset class is the next bubble.
I recognise some of early characteristics, rather like the early days of the tech bubble, but bubbles tend to take a surprisingly long time to inflate. Most investors’ allocation to emerging markets is still very small.
By the time we reach the top of this cycle, allocations will be much higher. At that point, there will be a noticeable lack of rational substance to investors’ decision-making – certainly less than today. If this is a bubble, there is plenty of money to be made as it continues inflating.
Elsewhere in the world, Europe poses some interesting questions.
Since the beginning of March, the region has outperformed the UK, the US and the overall world index. But scratch the surface and it is hard to see what has made investors in European stocks so enthusiastic.
Corporate leadership is certainly not the cause; many executives abandoned their forecasts in the crisis and complained about a lack of visibility. Nor is it a result of growing confidence in the banking sector.
Europe has not enjoyed any US-style banking stress tests or UK-style state-funded surgery. And there are still the underlying problems of Eastern European fragility. This includes the significant difficulties facing the many Eastern European consumers with euro loans from Western European banks they now cannot afford to repay.
The net result of this paradox is that I am cautious on Europe and therefore underweight.
Another area where I am less enthusiastic is corporate bonds. Credit spreads have narrowed so the corporate bond carry trade is worth considerably less than it was in the spring.
Some interesting investments are emerging in alternative assets classes. As investors’ risk appetite continues to grow, I have been shifting exposure to commercial property from physical property to Reits. As the cycle evolves, Reits offer the potential for higher returns.
Even further from mainstream asset allocation, the big shake-up of the hedge fund industry has opened doors for other investors. The past two years has dramatically reduced the number and size of people chasing each trade. This is good news for the remaining participants, as there are many more well-priced anomalies to exploit than last year. While allocations to alternative investments should be small for most investors forming a balanced portfolio, there are some interesting opportunities in that sector.
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