View from Psigma-
May 3rd, 2013
By Thomas Becket, Chief Investment Officer, Psigma, May 2013
It is no exaggeration to say that the world changed after the Great Financial Crisis of 2008-9. In particular, three features stand out to us, which we will discuss in this month’s update. The first is the increasing impact of central bankers upon financial markets. Another key change is the growing focus that investors now put on yield from investments, in an era of financial repression and record low interest rates. The final subject we will discuss is the crisis of confidence that has led to shorter economic cycles and increased volatility across asset markets.
The Old and New Rules of Investing
When most investors were taught the basic rules of investing, they were advised to consider three primary influences before deciding to “pull the trigger”. The first assessment was fundamental; is that region/ country/ sector or company benefitting from an economic tailwind or are there structural issues which will count against it? The second key element was valuation; are you paying an attractive price for the asset or is it over-valued? The final vital factor was sentiment; is the asset or investment too fashionable? Whilst far from easy, life was much simpler in those days. However, now the over-arching dynamic considered by most asset allocators and investors is how much liquidity central bankers are pouring in to their economies and what effect this wave of freshly printed money will have upon asset markets. Second guessing the central bankers is now a key determinant behind both asset allocation and instrument selection. This has created another layer of uncertainty and difficulty.
The Wave of Liquidity Created by Central Banks
At the moment the liquidity splurge is immense, as the US Federal Reserve (Fed) and the Bank of Japan (BoJ) have their printing presses cranked up to max-power and are using their fresh dollars and yen to buy huge swathes of their home bond markets and other assets, to the tune of $85bn and $75bn a month, respectively. There is also the expectation that the Europeans might follow suit and every indication that the new Governor of the Bank of England will also join the party. Their increasingly desperate aim is to ward off any deflationary spirits and help engender a lasting recovery, which has been lacking since the world started to recover in 2009. This sort of financial experiment has never been tried on the same scale and the consequences and side-effects are totally unknown. Indeed, the previous examples of such action have had decidedly mixed results, which is why the Fed and BoJ have gone “all in” this time to try and increase efficacy through massive size. Investors have seen the helping hand of central bankers as a pillar of support for asset markets and many argue that a wanted side-effect is a rise in asset prices, to help boost the “wealth effect” and, by implication, consumption. There have been supportive statements made by many guardians of monetary policy that this is indeed the case.
Increased Liquidity = Increased Volatility
The actions of the Bank of Japan have sparked a great deal of volatility across all financial markets, both at home in Japan and elsewhere. Indeed, the “crash” that we saw in the Gold market in April probably had its immediate roots in the ripples caused by the Japanese liquidity wave. Gold is a classic example of the volatility that investors around the world have had to endure over the last few years and a key illustration why it is vital to ensure that they hold ample diversification across their assets and do not have a concentration of risk. Having fallen from $1,600 to $1,380 in a mere couple of sessions, the Gold price has regained its poise and recovered to $1,470. Making the next judgement call on Gold is perilously difficult at this juncture, although we still favour an allocation to the yellow metal across portfolios, as an insurance policy against the printing policies of central banks.
The Stealth “Risk off Rally”
Whilst Gold is a graphic example of the distortions that have been effected upon markets by the creation of trillions of dollars of new money, the most lasting impact of the central bankers’ “zero interest rate policy” has been a significant re-pricing of any investment with a yield. Investors and savers are desperate for income and the clamour for yield has driven many assets to unrealistically high valuations. Gradually the central bankers have shoved investors out along the “risk curve”, starting with government bonds, through all types of corporate credit and now in to real estate and equities. Over the last few months there has been a belated return of positive sentiment towards equities, with some money flowing out of cash and in to shares. However, this inflow is a mere dent in the level of outflows that equities have suffered in the last few years. Indeed the US equity market has doubled in the last four years, despite net outflows of money from US equities! The new money coming in to equity markets is mostly going to high quality “defensive” businesses, with strong balance sheets and healthy dividend yields. This has led to a rare phenomenon of “boring but worthy” sectors such as Utilities, Healthcare and Consumer Staples leading the market higher in the recent rally. We have had a high weighting to such investments over the last few years through our “defensive delights” theme, but we believe that now is the time to start reducing expensive investments such as these and to focus on better value, long term opportunities. We don’t believe that defensive equities will necessarily be bad performers in the years ahead, but we believe that their best days are behind them.
But where is there Value?
Another key pillar of the investment education that I received was the concept of “Growth at the Right Price”, or “GARP” for short. However, investors appear to have given up on the quest for growth over the last few years, as they have become increasingly obsessed with income. Indeed the current investment decisions have been driven by “Yield at the Right Price”. Sadly, whether we are talking about fixed interest or equities, most income assets have become prohibitively expensive, with the exception of some of the interesting but niche fixed interest investments we bought in the first few months of 2013. However, that does not mean that we should despair as the “one track minded” nature of investment decisions driven by income has left some pockets of outstanding value across global equity markets, which we are now seeking to exploit. Our investment process has identified opportunities in “value” equities, particularly under-priced growth companies, in Europe, Japan and the Emerging Markets. Some of these assets, such as industrial and financial companies, are trading on relative valuations that have rarely been seen before and present outstanding value. Ironically, many actually pay healthy dividends to investors and have the potential to grow that income stream in the coming years. We would be naïve to suggest that such assets will not be volatile, but we feel strongly that with patience they will be highly rewarding over the next few years.
Confidence Remains in Short Supply
Despite the best efforts of the central bankers, the world is still suffering from an insipid economic recovery, primarily driven by a vacuum of confidence. As we have written in previous newsletters, the politicians are at least partly to blame for the lack of confidence, which has caused corporate management to be very cautious in their expenditure and reluctant to invest in their businesses. This has been the primary factor behind truncated economic cycles and has contributed towards the “summer swoons” suffered by the global economy in each of the last three years. Disappointingly, we are starting to see some of the early signs of yet another unwanted summer pause, which has led to the recent underperformance of cyclical equity sectors and Emerging Market equities. Whilst we are concerned about any economic cooling, our central case is that any slowdown will be not be too macabre and it is simply further evidence for the “Boring, Below-Par, Bumpy and Brittle” economic recovery we have described for the last four years, which the central bankers are doing their utmost to improve. Our view remains that the global economy should continue its gradual improvement through the remainder of 2013 and could accelerate in to 2014, which would be good for general confidence and supportive of a prolongation of the equity market rally that started four years ago. However, we believe that recent economic data and market distortions, such as the events in the gold market, should reinforce our approach to investment management, namely diversification, a sensible balance and ensuring there are no concentrated risks in our portfolios.
Despite our short term concerns over a potential slowdown in the global economy, we remain “cautiously optimistic” about asset market returns for the coming years. Indeed, our enthusiasm has been strengthened by the “value” opportunities we identified earlier this year in fixed interest markets and new ideas we have found in global equity markets. However, we will not be radically altering the balance of our investment strategy and will not be aggressively adding to risk, as we are respectful of the challenges the global economy still has to overcome. However, we recognise that the influence of central bankers is a force to be understood and incorporated within our investment thinking. The “Invisible Touch” of central bankers has changed the world and financial markets, creating both opportunities and worrying distortions. Nobody, ourselves included, knows how this financial experiment will end and we will heed the words of Genesis who sang; “she’s got something you just can’t trust, it’s something mysterious and now it seems I’m falling, falling for her”. We remain on our guard and ready to change strategy if the world changes again, as it so obviously has in the last few years.