We’ve focused much of our attention this year on the ongoing high volatility in currency markets and its effect on economies and asset prices as countries adjust to new exchange rate dynamics. China entered the fray this week as the People’s Bank of China (PBOC) devalued the Yuan by 4.65% against the US dollar. Additionally the PBOC has announced changes to its exchange rate policy which will allow the Yuan to float more freely on international markets, the most significant change to Chinese exchange rate policy since 1994.
Markets have reacted negatively to the news, as fears spread that the Chinese economy is in worse shape than previously thought. People are also concerned that China will begin exporting deflation to the rest of the world through its currency devaluation. We think such panic is premature. This exchange rate reform is partially politically driven as China seeks reserve currency status from the International Monetary Fund (IMF) later this year. In addition, it is unlikely that the PBOC will allow the Yuan to depreciate too significantly, because Chinese corporations hold large amounts of dollar-denominated debt.
Meanwhile, the European economy continues to improve, despite the latest installment of the ongoing Greek debt negotiations. As economic confidence has improved, banks have eased lending standards, allowing private sector lending—the lifeblood of any economy—to expand.
In the US, all eyes continue to be on the Fed and its interest rate decision. We maintain that it is the pace of rate hikes rather than the timing which matters most. Furthermore, it is not necessarily negative for asset prices if the Fed decides to hike rates in September—markets may take it as a sign of confidence.
We hold a large position in developed market equities and have relatively lower exposure to fixed income. Overall, our GTA portfolio holds 36% dollar denominated fixed income, 24% US equities, 30% international equities, 8% alternatives, and 2% cash and equivalents. We favor equities to fixed income, and have limited our foreign currency and commodity exposure.
Our exposure in fixed income is limited to dollar denominated securities. We hold positions in high yield bonds, preferred stock, mid-duration US treasuries, and dollar denominated emerging market debt. We recently reduced the duration of our treasury holdings in order to reduce portfolio interest rate risk. We have also trimmed our position in emerging market bonds as slowing growth and capital outflows in China are a source of concern for emerging market countries.
International equities rebounded nicely from their recent sell-off, and continue to outperform their US peers year-to-date. We expect this outperformance to continue in the second half of the year, and have maintained our large foreign equity allocation.
We expect the ECB’s quantitative easing program to continue to drive European equity outperformance. Our European equity exposure is split evenly between hedged and unhedged with respect to the euro in order to minimize the impact of high currency volatility. Spanish equities in particular are attractive after underperforming in recent years, and provide very good relative value to other Eurozone equities.
We hold a position in hedged-yen Japanese equities. Favorable policy will continue to put pressure on the yen, which directly benefits this position. Because unhedged Japanese equities are sensitive to the economic slowdown in China and do not benefit from a weak yen, we have sold our position in them.
We hold a position in mortgage REITS. We do not expect the interest
rate curve to flatten too severely in the intermediate term, which should support mortgage REITS.
*Emerging Markets allocation overlaps with regional allocations
**Excluding GTA’s 46% fixed income, alternative, and cash positions
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