Smart portfolio – Aside from a few days of volatility, markets have risen steadily this year. So how should you position your portfolio in an environment where risk assets may continue to move in lockstep?

Since February, markets have generally been on a steady rise, aside from a few volatile days around the British vote to leave the European Union. But it is important to remember that financial assets are highly susceptible to changes in central bank policy. With the Fed hinting at a rate increase, investors should prepare for the possibility of a taper tantrum scenario in which most risk assets experience negative returns at the same time. With that as the backdrop, here are six areas of the market worth watching in the fourth quarter.

  1. Equities — Emerging markets are beginning to outperform

After years of underperformance, emerging market (EM) equities are beginning to outperform developed markets. GDP growth in EM economies is expected to modestly accelerate, widening the gap between emerging and developed market growth. We expect this trend to continue.

Rising GDP differential signals better emerging market performance

Emerging market to developed market GDP growth differential

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Smart Portfolio

Smart Portfolio

Source: International Monetary Fund, Bloomberg and Columbia Management Investment Advisers, LLC as of April 2016

  1. Japan — A weaker yen benefits Japanese equities

Japanese equities look cheap, as earnings have grown over the past 12 months and share prices have fallen. Monetary authorities in Japan have been trying to stimulate the economy through aggressive quantitative easing and, most recently, through the announcement of yield curve management. But market participants question whether the Bank of Japan policies are effective and the yen has strengthened significantly. After recently weakening on expectations of a December hike, we expect the yen to eventually weaken against the dollar, which would benefit Japanese equities.

  1. Europe — Political unknowns demand caution

In the aftermath of the Brexit vote, the pound has continued to weaken. This has aided British exporters and raised the U.K. stock market. However, the British government has yet to initiate negotiations with their European counterparts, and the long-term economic impacts may not be known for some time. More recently, the U.K. markets and the price of the pound have been volatile, reacting to Prime Minister Theresa May’s hardline stance on separation from the eurozone.

Although European economies are modestly growing and monetary policy is supportive, caution is still prudent. A fourth quarter calendar heavy with elections, including the Italian referendum on constitutional reform, keeps us wary of political risk rising in the eurozone.

  1. TIPS — They look appealing with higher inflation trends

Our research suggests slow economic growth in the U.S. and modestly higher inflation trends in the coming months, mainly as a result of stabilization in energy prices. Historically, Treasury inflation-protected bonds (TIPS) tend to outperform when inflation is accelerating, and so we expect TIPS to perform better than nominal Treasury bonds.

  1. Alternatives — Despite recent underperformance, alts are still diversifiers

Although they haven’t proven it recently, alternatives have the potential to diversify portfolios beyond stocks and bonds. Within alternatives, momentum and carry factors favor commodities. Active, market neutral and systematic strategies continue to struggle, perhaps due to investor appetite for passive investments. Adding a volatility position when pricing becomes favorable and searching for hedging positions may help offset simultaneous declines across asset classes.

  1. Currencies — Mixed messages, but one is clear: the euro is under pressure

We’re getting mixed messages from our currency research. Our models predict a stronger U.S. dollar versus most major currencies. And while investing in the dollar has itself been an effective component of a tantrum hedge strategy, a weaker dollar would be more compatible with our preference for EM stocks and commodities. We continue to predict a weaker euro. European assets are likely to be seen as unattractive with banks struggling across the region and political uncertainty rising in the fourth quarter.

Bottom line

The theme of gradually rising prices for risk assets with the aid of supportive central bank policies remains intact. Investors should look for opportunity and prepare their portfolios for the possibility of a taper tantrum if there is a shift in central bank policy.

Article by Anwiti Bahuguna, Columbia Threadneedle Investments

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