CIO Blog: It was the best of times, it was the worst of times

August tends to be a sleepy month in markets, with many finance professionals away with friends and family, reading classic literature as opposed to finance news – the title of this blog is borrowed from A Tale of Two Cities by Charles Dickens – and resetting their internal batteries. Indeed, for the month of August, the S&P 500 did not have a daily move of 1% in any direction (and the FTSE 100 did so only once), which was a much-needed lull in a year when markets, across asset classes, have careered wildly. In lockstep, the volatility index (VIX), a barometer of expected movement in markets, is currently below its historical average and well below the spikes witnessed early in the year and again around the “Brexit” referendum.

Given this gift of calm, let us reflect on the year so far. Equities continue to rally, with the S&P 500 near its all-time high, the FTSE 100 up 9% on the year and emerging market equities, up 10% in local currency terms, back in vogue. The returns represent a staggering comeback from the first quarter when they were each down at least 10%.

However, this most recent upturn in the multi-year equity bull market has not been characterised by gung-ho sentiment or much of a feel-good factor. Safe-haven German and Japanese bonds maturing a decade from now offer negative yields and UK government bond yields are at record lows across the yield curve: 30-year gilts yield just 1.23%, while those with maturities of five years and below are yielding next to nothing. Furthermore, assets that are popular crisis hedges, such as gold and the Japanese yen, have also rallied by 23% and 17% so far in 2016, respectively (in US dollar terms to the end of August).

The state of the ocean

Nearly a decade on from the financial crisis, global economic growth is still insipid in spite of the colossal efforts of central banks around the world to stoke growth. These efforts, while largely fruitless in their primary cause, continue to underpin equity and bond markets. The Bank of England, the European Central Bank and the Bank of Japan are directly and actively intervening in financial markets, buying government and corporate bonds, bidding prices up and yields down. Even the US Federal Reserve, while not actively buying assets at present, continues to flip-flop on the trajectory of its interest rate increases; US bond yields also remain at record lows.

Financial institutions – the counterparties to the central banks’ monetary policy expansion – keep finding themselves with excess cash in return for the bonds they are selling. This cash, in turn, continues to be ploughed into assets such as equities. This elaborate dance has been resplendent since the onset of the financial crisis. It has not changed.

The lower the yields are on government bonds, the more attractive equities appear in comparison. Many investors are holding more equity risk in portfolios to get “pre-crisis returns”. For example, at the end of 2007, a portfolio comprising global equities and government bonds in equal proportion had an expected return of 5.5% (expected returns are based on the average five-year historical return from the starting valuation). Today it can be expected to generate about 3.5%. To achieve 5.5% currently, the portfolio would have to be positioned at 80% in equities, making it far riskier. The alternative is to settle for lower returns for the same level of risk, an unattractive option for some investors.

The monetary easing that is taking place around the world, while supportive of risk assets, carries serious risks. First, pushing most investors further along the risk continuum increases overall systemic risk in markets – something that has been outlined at the past few G20 summits. Second, low rates and bond-buying cannot continue indefinitely. The potential ramifications of what can happen when it does include sudden and savage re-ratings for equities and bonds. Third, and perhaps most importantly, there is no substitute for economic growth. While it is not correlated with asset class returns in the short run, it influences returns in the long run. Markets would prefer risk assets underpinned by healthy long-term economic fundamentals rather than short-term monetary ones. 

The sharks in the water

In addition to the above, a number of other economic and geopolitical risks muddy the waters further. In February 2016, equity and commodity markets were in freefall due to fears of a slowdown in the Chinese economy. In June and July, markets experienced ructions again following the UK public’s decision to sever its membership of the European Union (EU). Both of these issues remain ongoing and unresolved.

In terms of the Chinese economy, the state-controlled depreciation of the renminbi continues. The implication that Chinese authorities have faltering faith in their own growth prospects caused concern. In addition, a Chinese real estate bubble, built on debt and speculation, continues to get larger.

In the UK, while the sentiment gauges may have overshot on pessimism in the early days following Brexit, actual data seems to have held up well. Nonetheless, most economic forecasters still believe “Brexit” will lead to at least a short-term loss in GDP, with a longer-term recession possible. Also, while Theresa May took over the role of prime minister quickly and easily, negotiations with the EU and the actual invocation of Article 50 remain. The task at hand is enormous – with Whitehall and Westminster having to decouple the UK from more than 40 years of EU law – and fraught with potential missteps.

Also looming large is the US election. Investors, and others, are scrambling to separate Donald Trump’s bombast from his actual policy. At present, his proposals centre on rhetoric (“ban trade”, “build a wall”), with few details on how they will be funded. Conservative estimates are that they will cost trillions and even doubling the historical GDP growth rate (impossible) will not make up the shortfall. A Clinton presidency may be more palatable to markets (the first time that has been said of a Democrat over a Republican candidate in decades). Markets are likely to remain volatile leading up to the election. Perhaps more importantly though, the winner will govern a country more polarised than it has been for many years - something that does not bode well for a country that represents one-fifth of global GDP.

These are some of the triggers to equity markets sputtering, faltering or plummeting, but the list is far from exhaustive.

Investment implications

While we recognise a discomforting backdrop to global markets, we remain sanguine: equities are still our most significant allocation. Why? The asset class appears attractive, not only in comparison to bonds, but also in absolute terms. Equities offer some value across a number of measures (for example price-to-book ratio). Moreover, equities continue to be supported by strong momentum and bearish sentiment, both strongly supportive factors in our investment process. We believe these are more important drivers of returns than monetary dynamics or geopolitics.

However, we recognise that markets can move with staggering speed and we continue to have significant allocations to government bonds in spite of record low yields and high valuations. They are held primarily to diversify away from equity risk. But that is not the only reason. Government bonds are also in positive momentum and surrounded by negative sentiment, both aspects we like. It is prudent to remember that they have delivered excellent returns over the last one, three and five-year periods through conditions similar to today – a surprise to many. It is more than possible that they will continue to surprise, particularly given current monetary policy conditions.

As another form of defence, we have increased our cash allocation in recent years for two key reasons. First, it gives us a flexible position to capitalise on attractive investment opportunities (such as commodities), and reduces volatility from potential risks of all kinds, including the geopolitical. Second, it is a core asset class. It may not generate much in the way of return, but it does not lose nominal value – the most effective form of protection if and when volatility for risk assets increases.

In terms of other assets, we see an attractive nexus of cheap value, positive momentum and bearish sentiment in commodities. Following precipitous falls in the prices of a diversified commodity basket after a five-year bear market, a floor in oil prices proved a catalyst for the asset class to regain positive momentum from a position of compelling valuations. We re-entered the asset class following a three-year hiatus in April, and may well add to that position if the investment case prevails.

Lastly, we took profits on all of our long-standing UK commercial real estate positions a few months ago, avoiding the “Brexit”-triggered carnage that took place in the asset class. Until recently, commercial real estate was the darling of most investment portfolios, providing a decent yield and strong capital appreciation in a low-return world. Yet even before “Brexit” valuations were becoming stretched, momentum was faltering and complacency had set in. Those were the triggers that led us to exit the trade earlier this year.

In conclusion, the summer appears to have provided a period of calm for markets and an opportunity for most to step back and reflect on the big picture. No doubt the months ahead will bring further uncertainty and volatility to markets. We stand ready by our investment process to navigate the uncertainty and capture the opportunities.

Sources: Factset, Kleinwort Benson


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