Lead Piping in the Library…
As ‘Anxiety’ is my middle name I recently looked back on my 2008 newsletters to see if I could find any parallels as we approach the 10th anniversary of the big crash. With increasing concern I had entitled the 2008 quarterlies ‘When the Music Stops’, ‘A Two Pipe Problem’, ‘Darkness on the Edge of Town’ and finally ‘Buddy Can You Spare a Dime’, the evocative lament of the Great Depression. Via Wall Street titan Chuck Prince, Sherlock Holmes, Bruce Springsteen and Bing Crosby I had moved through concern, bafflement, impending doom and eventual despair. History has a tendency to repeat itself in different ways and causes of crashes tend to turn up in places where investors are complacent and regulators aren’t looking. Some truths though are universal and the most useful thing I wrote then, and would repeat today, was that in very liquid, risk accepting markets most things go up whether they are good value or not; ‘All turkeys fly in a gale’ as the saying goes. However, when the liquidity evaporates these turkeys very quickly become Christmas dinners and in a risk averse, bear market cheap assets stay cheap because suspicion and trepidation hang heavy with a lack of trust in anything or anyone. With US 10 year bond yields hitting 3% and the Central Banks beginning to turn off the money printing taps then the ‘price of risk’ has increased at the same time as liquidity is being withdrawn from the system. Hmm… Financial crises typically involve excessive leverage, illiquidity, and ‘contagion’ across asset classes. Colonel Mustard this time could be the corporate and High Yield credit markets where illiquidity combined with declining credit quality, increased leverage and tight spreads provide motive and opportunity.
The first half of the year proved to be a disappointment after the strong growth and continual ‘upward surprises’ of 2017. Growth is still pretty solid but has dipped in all the major economies with both long standing locomotive the US and newly minted ‘golden boy’ Europe producing a muted Q1. Leading global economic indicators are beginning to roll over and headwinds are increasing with the significantly higher oil price and increased trade tension as you- know-who enacts his ‘America first’ policy. The rise in the US 10 year bond (the ‘price of risk’) and rebound in the US dollar is turning the screw on the emerging markets with pain already being felt in Brazil, Argentina and Turkey. Nevertheless, whilst there may have been a loss of momentum, the risk of a meaningful global slowdown remains low and expectations are for a strong rebound in US growth in Q2. Inflation remains muted, though the higher oil price and tightness of the US labour market will cause some upward pressure on prices.
Markets…testing the nerves
The year to date has been a game of two quarters, a roller coaster ride with increased volatility and a pronounced V shape in equity markets. Fixed Income markets have suffered rising bond yields and widening credit spreads, especially in riskier assets such as Emerging Market Debt and High Yield. So where do we go from here? Markets typically peak six months before a recession and as there is no sign of this on the horizon then simplistically we have little to fear for the remainder of 2018. Global growth remains sets fair, inflation is muted and earnings growth remains strong. Equity valuations are extended but they are cheaper than they were 12 months ago as earnings have outpaced share prices; the P/E on the S&P500 is 16x forward earnings compared to 18x a year ago and the UK a far from scary 13.5x with a dividend yield approaching 4%. Central Banks are moving towards tightening but this should be gradual and well communicated. So why am I feeling a bit queasy? Maybe because whereas three years ago investors worried only about the economic backdrop and paid minimal attention to politics we are rapidly reaching a point where the reverse is true with Trump, trade, nationalism, Eurozone dysfunctionality and Brexit driving share prices, not the traditional fundamentals. Looking from a wider aspect, there are meaningful changes in long term trends with strong, multi-decade tailwinds abating and becoming long term headwinds. Tighter Central Bank monetary policy, falling liquidity, rising interest rates, higher bond yields and more restricted credit are all adverse major change whilst protectionism, nationalism, autocracy and confrontation are threatening free trade, globalisation, democracy and co-operation. Consequently though the medium term outlook for equities may look fine in theory, in practice there are too many random banana skins to allow investors to be as relaxed as earnings growth and valuations would imply. Until we get a much stronger sense that an economic slowdown is appearing on the horizon we remain ‘constructive’ on equity markets but our central case is for only low to mid-single digit nominal returns over the next few years with a lot more volatility and an increased risk of capital loss.
Fixed Income markets remain a difficult place to make any money. Bond yields should continue to move higher with the firming global economy and Central Bank tightening. Yield curves are flattening which reduces the opportunity to seek higher yield through buying longer dated bonds whilst credit spreads are widening which further erodes capital. However, we see this as a benign rather than savage bear market, with only a gradual and shallow increase in yields and a terminal rate well below that seen in our lifetimes. Our memory is distorted by the super high interest rates of the inflationary 1970/1980s which were in themselves the outlier rather than the norm with much of the 35 year bull market in bonds being a correction from the anomaly of 10 year yields of 15% in the US and UK. It is only post 2009 that yields became ‘too low’ by historical standards. The US 10 year yield has moved out from 1.5% two years ago to nearly 3% today and our sense is that the terminal rate may settle not too much above 3.5%. This should not do too much further damage to portfolios and at that level investors will begin to welcome rather than avoid longer duration.
The Curious Case of the Flattening Yield Curve
This is prima facie not the most appealing of the lost Sir Arthur Conan Doyle masterpieces but is actually an intriguing puzzle with an as yet unknown outcome. Solving it would help us enormously in plotting the way ahead for equities and bonds. It is well understood that US bond yields have risen sharply this year but less appreciated is how much the yield curve has flattened (i.e. short dated yields have risen considerably but long dated yields far less so) such that the gap between two and ten year Treasuries is now only around 0.3%. This typically implies low inflation and sluggish growth and is seen as a classic indicator of impending recession. This is considerably at odds with consensus economic thinking (three very dangerous words!) which expects growth to remain resilient and inflation to be an ongoing concern given the tightness in the labour market. If the ‘flattening’ indicator is right then equities are in for a nasty shock but bonds offer fair value at current levels; if the ‘economic consensus’ is right then bond yields remain under upward pressure and equities look set fair for the foreseeable future.
As usual with the behaviour in financial markets since 2008, the answer to the conundrum possibly lies with Central Bank behaviour and the vast distortions their quantitative easing programmes have created. There will be a huge issuance of debt by the US Treasury to finance the expanding budget deficit but (unlike in previous years) far less buying by the Federal Reserve to support it and hence a big increase in the issuance of short term bills. The US primary dealers are obliged to take up the slack and buy the bills, which is putting pressure on short yields hence flattening the curve. The very wise bond boffins at Twenty Four Asset Management do not expect the curve to invert till recession looks well and truly on the cards, the consensus for which is at least two years out, though maybe the 2/10 curve could flatten out at around 3.25% sometime during next year.
Getting from A to B
Investors frequently watch the markets on an almost daily basis and become fixated with short term performance and I am well aware that quarterly valuations feed this obsession. I can completely understand why this happens but ideally you should stand back and think about the objective of your investment portfolio, which can be best thought of as a journey from A to B where
A is when you started investing
B is when you need to start utilising you investment, which in many cases will be your retirement
In reality the journey itself is not important, what is important is arriving at your destination with your portfolio at the sufficient size to meet your financial/lifestyle objectives. Good financial planning will have you investing the appropriate amount of money in the correct risk/reward portfolio; it is then the job of your investment manager to deliver to your reasonable expectations.
So what are reasonable expectations?
Based on long term asset class returns dating back many decades we would expect our Model Portfolios to produce the following long term annualised returns.
||Inflation + 4%
If you consider the long term rate of inflation to be 2%, then your nominal return is going to be Cautious 3%, Conservative 4% etc.
The journey of course can be distracting, even disturbing, at times; markets fall as well as rise, sometimes very disconcertingly. However, if you are a long term investor with many years ahead then this should be ignored, however difficult this will feel at the time. We appreciate that for some investors the short term risk of capital loss is critical and can be very detrimental to their standard of living. Portfolios are constructed in such a way to reflect this, which we do by building them so they have a volatility and risk of capital loss that can be demonstrated by their relationship with the best known investment benchmark, the FTSE 100. Each Model has a relationship against the index which shows how much we expect them to rise and fall when the index itself rises and falls
||25% (i.e. if the FTSE rises/falls by 10% a Cautious Portfolio should rise/fall by 2.5%)
As investment managers we are always trying to be asymmetric in our returns, capturing a bit more of the projected upside and mitigating a little less of the projected downside. So long as Portfolios are producing their reasonably expected returns over the long term and demonstrating their anticipated volatility then they are navigating the journey well and will reach their destination successfully.
Investor psychology has been dominated over the last 10 years by binary growth vs. value and cyclical vs. defensive trends and 2018 is shaping up the same way with growth significantly outperforming value. Best performing equity market sectors are technology (yet again!) and consumer discretionary whilst the defensive ‘bond proxy’ sectors such as consumer staples, telecoms and utilities continue to take a pasting, as have financials. The Lazarus award goes to the energy sector with the big rise in the oil price propelling the sector from the outhouse, where it has languished for many quarters, to the penthouse. US fund returns have been strongest for the sterling denominated investor, helped by the translation effect of a strong dollar. EM funds have struggled in the face of a stronger dollar, tighter US monetary policy and tariff tensions whilst the UK appears to be shifting from pariah status to ‘interesting contrarian play’. Rising bond yields and widening credit spreads have meant an uphill struggle for all Fixed Income funds whilst some of our Absolute Return and conservative multi-assets funds continue to underwhelm.