The strong market rally since the end of June took many investors to an uncomfortable place: many missed it altogether. Even for those who have benefited from the rise in asset prices this year, the current situation in both bonds and equities puts them in a difficult spot. So what should investors do now?
The strong market rally since the end of June has taken many investors to an uncomfortable place: many missed it altogether. The average hedge fund has made less than 1% year-to-date, and the average Targeted Absolute Return fund in the Investment Association sector classification has barely crept above zero. Even for those who have benefited from the rise in asset prices this year, the current situation in both bonds and equities puts them in a difficult spot. Congratulations to those investors who have held long-dated bonds and ridden them to new record low yields, recording sharp capital gains. But what now?
Yields hardly looked interesting at 2% for a ten year Gilt at the beginning of the year. Despite a Bank of England rate cut and the prospect of more Quantitative Easing (QE) across the globe, ten-year Gilts looked dangerous, priced to yield just 0.65% at the end of August (far short of core inflation at around 1.3%). The experience of the last few years shows that nothing is unthinkable in a world driven by infinite QE: think zero yields or even negative yields for long-dated bonds. But, even if yields fall to zero on the 10 year Gilt, further returns are mathematically constrained – scope for no more than a modest capital gain, versus scope for significant capital losses if yields rise. With yields so low, it needs only a marginal increase for the corresponding price fall to wipe out a year’s income.
So what could possibly justify holding government bonds at such low yields? Expectations of recession and deflation certainly would. This would drive yields even lower and well into negative territory. However that sort of scenario is a long way from consensus, which anticipates subdued but steady growth and some upward inflationary pressures. Expectations that bonds bought now could be sold at a profit to central banks undertaking ever more QE might justify holding Gilts, Bunds or Japanese Government Bonds. Central bankers though are becoming aware of the negative impacts of QE, and we cannot take for granted that government bond purchases will expand forever. There is value to be found, but sometimes it comes with other baggage.
Relative value across different bond markets might justify some positions. US Treasuries, for example, yield almost 1% more than Gilts and still offer some return potential in plausible scenarios. Regulatory directives or risk management pressures force some investors to hold low yielding government bonds. Those not forced to do so might struggle to explain their actions if yields do rise, causing capital losses.
What about equities, where investors have also seen explosive gains? We must be careful not to fall into the ‘money illusion’ when looking at UK equities. The FTSE 100 is up nearly 10% this year, but the Pound has fallen over 13% against a basket of its trading partners. The market’s rise, particularly in the period since Brexit, partly reflects the impact of the weak currency driving a repricing of companies that derive the vast majority of their revenues from overseas. Equally, the global investor looking at the FTSE 100 in US Dollar or Euro terms will see an index that has actually fallen this year. In local currency terms, global equities gained about 5% this year, as at the end of August. Of these the US and Emerging Markets have been doing better, while Europe and especially Japan have been doing much worse.
However, this has taken place against the backdrop of falling earnings expectations and stocks have generally become more expensive relative to earnings. This is perfectly justifiable if we expect earnings to accelerate in the years ahead, and we might reasonably argue that sector specific problems (in the energy sector in particular) are fading. However it’s harder to justify when economic growth expectations are subdued. The sense of equities as a default investment choice, selected reluctantly by investors because cash offers no return and bonds offer no return with the prospect of volatility and capital losses, becomes hard to shake off. That is, unless we start to see hard evidence that companies are able to convert economic growth into much more robust earnings growth.
We are left with an uninspiring but relatively unthreatening economic outlook. The deep growth scares of the last year or so look misplaced and we see low probability of a major global slowdown in the next 12 months. The UK, of course, faces more uncertainty, particularly in the area of capital investment and the prospects for higher inflation thanks to expensive imports. But nor do we see strong drivers for a major acceleration in global growth. Consumers have capacity to increase spending, but confidence may not be strong enough; wages can rise, but the pace of US job creation seems to be slowing; corporate capital expenditure is recovering from the oil sector shock of the last year or two, but is not yet buoyant enough to drive a broader recovery.
Central bankers and economic commentators have been calling for governments to provide a meaningful fiscal boost – borrowing at historically low costs to fund infrastructure and other spending programmes. This could boost growth – but the political appetite to do so is limited. There will be periodic scares and thrills, but we see little to drive a major shift in the growth outlook at the moment.
We think markets’ focus will shift increasingly to policy over the next year, particularly monetary policy. While our expectations for the path of economic growth over the next year have narrowed, the range of possible courses that could be followed by central banks and national exchequers seems wider. Headline inflation is likely to rise in the US and UK, given that energy prices have stopped falling and currency moves will feed through to consumer prices. That’s a direct opportunity that we are looking to exploit through the inflation protection certificates in our portfolios. However it also reduces the flexibility for central banks to act.
In the US, the Federal Reserve is still looking to increase interest rates, but the loose policies pursued by other central banks, and the risk of a much stronger US Dollar or a volatile equity market reaction, still seem to be constraints. In Europe and Japan, central banks have broken taboos by moving to negative interest rates and buying an ever-expanding range of financial assets. It’s unclear how much further these policies can be taken or how markets would react to ever larger asset purchases. The risks of a policy misstep – or an adverse market reaction to central bank communications – seem higher than usual.
So this is the challenge that investors face, particularly for those with a desire to manage shorter-term volatility, yet still achieve medium-term returns ahead of inflation. The subdued economic outlook, modest corporate earnings growth, policy uncertainty and relatively expensive assets make life difficult. There is value to be found, but sometimes it comes with other baggage, such as illiquidity, complexity or political risk. This is an environment where asset prices can be much more volatile than seems justified by an economic environment that is rather stable and where traditional portfolio protectors (government bonds) no longer play their stabilising role. Indeed they seem to introduce risks all of their own. In such a world, we need to be nimble. We will be investing where we see value emerge, but we will not be afraid to take a profit and hold diverse sources of protection in our portfolios for an uncertain world.
Deputy Chief Investment Officer
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