27 July 2016 /
The current economic and political background for investment markets is complex because we are operating in an environment which has no historical precedent. One sign of the unusual economic backdrop is the pervasive low nominal and real interest rates in the world despite the enormous expansion of central bank balance sheets in the developed economies. The inability of the global economy to gain growth traction or an inflationary impulse highlights the unique economic conditions we are facing.
The current economic morass has a number of causes including demographic trends, the aftershocks of the Global Financial Crisis, heightened regulation, technology and the effect of negative interest rates.
One of the consequences for portfolio investment has been the ever higher price investors have been prepared to pay for any asset that pays a coupon or dividend. This also includes accepting liquidity terms that would be impossible to meet in the event of large-scale withdrawals, such as just occurred with some open-ended UK real estate funds. This has led to extraordinary value dispersion between income and growth equity.
There are also political consequences, of which Brexit is one, partly due to the rise in wealth inequality as those who have equity benefit from rising prices whilst those dependent on income see their purchasing power reduced. These socio-economic factors may result in more unexpected election outcomes and possible sharp changes in policy direction in the US and Europe over the course of the next year. Ordinarily markets shrug-off political events but not if there is a potential policy consequence.
In general, the macro economic landscape continues to be one of slowing economic growth, waning growth in corporate earnings and high valuations for financial assets reflecting the declining discount rate.
However, there are micro economic trends that paint a very different picture; the advancement in data storage and computing speed, which has now reached epic proportions, is accelerating developments in science and technology creating highly disruptive companies that undermine existing business models. This is not a new development but the speed of the change now appears to be faster than society’s ability to create new jobs. Hand-in-hand with this is the creation of enormous wealth by a few in a short space of time.
Against this background we consider three scenarios are likely to emerge. The first, which is unsustainable, is a continuation of the current investment environment with financial asset prices buoyed by central bank liquidity. Global growth is uninterrupted but slow. The demand for income drives the wedge between growth and income to ever higher scales, punctuated by bouts of sharp price re-adjustment. Opportunities for wealth creation remain in the private equity market with public companies buying private companies rather than investing in themselves.
The second is that political forces respond to the current economic difficulties with sharp changes in policy resulting in a possible loss of confidence in financial assets and fiat money. Interest rates rise escalating debt servicing costs resulting in the start of the debt cleansing process which has largely been absent since the debt crisis of 2009.
A third scenario is that the weight of money in expensive financial assets switches to real assets and ignites a long-run inflationary cycle.
There are of course many other possible outcomes but these three reflect the most likely in our view.
For the period 2009 – 2014 our investment strategy reflected the first scenario as the era of quantitative easing was in its infancy. We experienced a surge in asset prices in the first quarter of 2015 and sought to diversify portfolios to allow for the different investment conditions. In various stages we raised cash and bar-belled growth and quality income equity strategies. We have pursued long term growth equity as we believe this taps into the disruptive value creating part of the economy.
The challenge for asset allocators is to make timely shifts as the drivers of asset prices change. Ordinarily this process is aided by economies following a reasonably predictable pattern of development from recession to growth to inflation back to recession. The only uncertainties are the timing and magnitude of the cycle.
We do not expect the economic cycle to follow such logic this time. Having previously taken the position that a ‘normally’ diversified portfolio may not result in the usual efficient portfolio management, we now sense that we are close to a tipping point where liquidity driven asset prices start to be weighed down by the macro economic problems of weak profit growth and either inflation or deflation which will be determined by the political direction of travel. If we are correct in our assessment then we believe an alternative approach to portfolio diversification is necessary.
To support our contention that we are closer to a change of scenario, we point to a number of recent developments:
- Recent weeks have been marked by discussion of the final stage of Quantitative Easing – helicopter money. This is the process where central banks finance government spending by printing money to buy newly issued government bonds. We do not know if this will happen but it has long been an expected end-game of the Global Financial Crisis and now the talk is louder the possibility is closer.
- Whilst the US economy continues to perform reasonably well and is the economy closest to pursuing conventional monetary policy, the rest of the world is not doing well. The greatest disappointment is once again the Eurozone. A year ago it was hoped that the economies were beginning to improve. However, the improvement has been spotty and the valuation collapse of bank shares is an early indicator of wider problems ahead. An economy cannot expand without a properly functioning banking system.
- Whilst very early days to make an assessment of the economic consequences of Brexit, it would not be surprising if the anticipated economic slowdown in the UK piles more woe on the EU economy, including additional pressure on the fragile banking system. Moreover, the direction of fiscal policy in the UK seems likely to take a very different path to the EU fiscal strait jacket. This could result in copycat policy measures by some economically struggling EU members.
- The emergence of negative nominal bond yields in some developed economies is an extraordinary development and is a strong signal of long term economic malaise due to the prolonged weakness of global capital spending. Negative interest rates suggest economies are consuming capital (very evident in Japan for example) rather than investing because the expected future return on investment is anticipated to be less than the cost of finance. Since future economic growth is dependent on current capital spending, the future does not look favourable.
There are some mildly supportive developments to put on the other side of the ledger. To the 2% growth rate of the US economy can be added stability in China, which has recovered from its policy wobbles last year, and a stabilisation of the oil price in the $40 – $50 range.
A diversified portfolio blunts investment performance as the purpose is to have assets that fare differently at the same time. Whilst bonds have performed far better than we had expected, we are cautious about their efficiency as a diversifier as they have pretty much travelled hand-in–hand with equities over the past 7 years. If the eventual undoing of lofty equity valuations is an inflation-induced interest rate rise, then equities and bonds will likely continue to travel together. If, however, equities are knocked by deflation then the two assets will almost certainly part company.
Our asset allocation conclusion was to sell more equity on rallies and these sales would primarily be from Japan and Europe. In particular we have decided to sell our exposure to European banks. Having initially seen their value rise appreciably, the latest EU woes have brought this sector to its knees. There is too much economic and political uncertainty to get a sense of what the real book value of the banking sector is. Japanese sales will be confined to index tracking funds as we continue to believe there are favourable domestic trends but these are best located by an active manager. We will also assess policy measures resulting from the Upper House elections in Japan in case these have consequences for either assets or the currency.
We have already invested in quality income assets which have done well. However, the P/E multiple of this strategy appears stretched, particularly given the depressed outlook for earnings, reflecting the popularity of this bond-type investment. Of course it is not a bond and we are monitoring the valuation aspect of these positions carefully.
An additional measure being taken is to switch some of the UK mid-cap exposure to internationally diversified large cap companies. The main driver for this is the pound which we expect to depreciate further if there is a new mix of easier fiscal and monetary policy. The large UK current account deficit (amounting to 7% of GDP) is an additional drag for the pound although the pound’s recent depreciation is likely to attract foreign buyers of UK assets.
To diversify the equity risk, we continue to use cash and index-linked government bonds (gilts or treasuries) and we have decided to increase both of these holdings. Additionally, and for only the second time in seven years, we are considering an allocation to gold for those clients who have provision for this asset class in their strategic asset allocation.
Gold is a highly contentious asset class and ordinarily we do not believe it has a useful role to play in portfolios that are geared towards wealth creation. The gold price, however, has the useful behavioural trait of generally moving in the opposite direction to equity prices, especially when equity markets are struggling. We are not expecting a major financial dislocation to occur as if this was the case we would not hold gold. We consider gold as an alternative currency. All the major currencies (USD, €, Y, £) potentially have a negative backdrop so gold can be a useful alternative. The attraction of gold is enhanced when interest rates are zero as the opportunity cost of holding a non-interest bearing asset is also zero. Our decision to hold gold should not be interpreted as an expectation about a possible Armageddon in financial markets.
We have considered investing in deep value assets such as emerging market equity and debt. Whilst we remain open to such opportunities and a good case can be made for some emerging market assets, their investment success largely hinges on developed economies maintaining a stable, if unexciting, economic course. We are not convinced that is the case today.
Overall, we are seeking to position portfolios to increase in value if markets continue to rise, albeit realistically not in step with the market indices due to the level of cash held. However, we feel insurance through diversification is worth having given the uncertainties ahead.
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