But the group will also plan for lower probability scenarios as a benchmark for the valuation of assets should the environment change. They have recently upgraded their hard-landing scenario, for example, which sees a slowdown in China, a significant reduction in US growth and a meaningful slide in eurozone and Japanese growth.
It recognises the effect this scenario would have on risk assets, such as equities and commodities, and appropriate pricing in that environment.
Graham says: “In 2015, we were happily travelling through the year, believing all was well, when the Chinese authorities revalued the renminbi. Suddenly, everyone thought the world was going to end. There was a point in February when equities had reached a level where they were pricing in a hard landing.
“We did not believe the fundamental data had changed. European and US growth had not started to slow and earnings had not fallen off a cliff. We concluded the world hadn’t changed so much and equity prices therefore looked attractive.”
The group’s ‘hard landing scenario’ is balanced with one of rosier growth. In this scenario, there would be synchronised growth across developed and emerging markets.
Best laid plans
BNP Paribas takes a broad-brush approach in its asset class selection. As a result, it has been invested in commodities, albeit largely in gold and agriculture, avoiding those sectors exposed to dollar fluctuations. In terms of implementation, it is selective in its use of active/passive. It would not use active funds for US large-cap funds, for example, but may do so for emerging markets where there are more opportunities to generate alpha.
Graham says: “There are long-term strategic holdings where we want active management, not just for outperformance but also because stock selection can be a diversifier, keeping risks under control.”
The group is actively looking to get alternatives into its portfolios. To date, it has focused on liquid alternatives, such as covered Reits, listed hedge funds and infrastructure, using part of its equity risk budget.
“For direct alternatives,” says Graham, “there is a debate over the liquidity available and whether our clients will allow us the five-10 years or so we would need to hold them. This might be true of direct property or private equity.”
Nevertheless, an innovation team looks at ways to replicate the returns of some of these illiquid asset classes in the portfolio.
There is more political risk around, which Graham manages as a subjective overlay, requiring greater upside potential to take the risk of various assets. In practice, this means lower valuations. “If the risk premium around European assets has gone up, the target prices and expected returns have gone down.”
Fixed income remains one of the thorniest dilemmas for asset allocators at present. Graham admits his team has reduced duration in the past 12 months, which has not worked well, but they are starting to change their thinking due to negative yields.
Graham says: “I cannot believe someone would lend to a government for 20 years and get less back at the end of that period. It doesn’t make sense to me.
“When I first started working in this area, there was a similar phenomenon. The equity risk premium was negative. Markets were suggesting that bonds were riskier in terms of volatility than equities.
“I wonder if, in five years’ time, we will look at the current situation with bond yields and wonder how we didn’t spot what was coming.”
These are certainly unusual times, and Graham remains cautious with his investors’ money.
Five key themes
Risk tactics
BNP Paribas kept a low risk positioning going into the referendum on the European Union, reducing its overweight in equities and selling some high-yield bonds. The group remained neutral on credit and did some tactical short-selling as well. It believed the situation did not look clear and that there were some key risks.
Credit where it’s due
It has not topped up equities since Brexit, given the speed of the sell-off and rebound, but has moved to an overweight position in US credit relative to European credit, where there is a slight yield advantage.
The harder they fall
The group recently upgraded its hard-landing scenario in the wake of Brexit, which sees a slowdown in China, a significant reduction in US growth and a meaningful slide in eurozone and Japanese growth.
Fed up?
BNP Paribas feels the market consensus on a rate rise by the Federal Reserve is too negative but agrees it could take time to work out the best time to go up. With the US presidential election in full swing, it is difficult to see another rate rise for the next six months.
Spread betting
The group is long US treasuries versus EU government bonds, seeing better returns in the US from a higher carry and a steeper yield curve, even if the Fed hikes gradually. Short term, it sees political risks in the eurozone, which could lead to higher peripheral spreads.
