…and their implications for how we are managing portfolios and their performance
It is now almost a decade since the Global Financial Crisis, and we believe that some of the most important drivers for financial markets that have prevailed through this period are now changing. It is normally the case that prices in financial markets move ahead of changes in fundamentals, and it is only in retrospect that movements can be explained with certainty. Conscious of this, we have been gradually evolving our positioning, which in summary has meant that our portfolios have become more conservative. An implication of this has been the increasing tendency for performance to become more muted, proving comparatively defensive in the short-lived setbacks seen over the past couple of years, but latterly lagging as most asset prices continue their march higher. Thus while long term performance remains very strong, our portfolios have generally struggled to keep up over the past six months and could continue to do so if current trends continue. While the risk profile and construction of our portfolios are designed with careful regard to their mandates, most are now positioned very differently to a majority of peers, and this can be seen in the Hawksmoor Funds’ pattern of performance compared with their respective IA Mixed Investment Sector Averages. What is influencing our thinking? What are the main threats and opportunities we see? And, how are the portfolios positioned in the light of this? We seek to provide answers to these questions below.
A summary of 10 important global trends that inform our investment policy
We are not far off the US economy having seen its longest ever period of economic expansion and spare capacity is becoming limited. This raises the chances that the expansion may end soon, although there are some mitigating factors, notably the fact that the quantum of growth in the current cycle is unexceptional as the pace of growth has been modest. In other words, the economic cycle may be prolonged compared with those in the past, because we have not yet seen high rates of growth which can trigger recessions when it leads to a rise in the rate of inflation and higher interest rates.
Monetary policy and, by connection the level of interest rates/bond yields, is extraordinary and we should not be tempted to treat them as anything other than that despite the fact that a decade on from the Global Financial Crisis many people now regard the current environment as ‘normal’. One thing that helps to illustrate the truth of this is the words of Andy Haldane in June 2013 “Let’s be clear. We’ve intentionally blown the biggest government bond bubble in history.” It is almost beyond irony that his title when he said this to the Treasury Select Committee was Director of Financial Stability! Five years on, the yields on many government bonds have fallen further, and UK base rates have only recently been edged up to 0.75%, still well short of the low of 2% which had held since the foundation of the Bank of England in 1694 prior to the Global Financial Crisis.
Very high levels of public debt and adverse demographics mean fiscal policy options to boost growth or combat a recession are quite constricted in most developed economies. Rising levels of debt are likely to mean that recent rates of economic growth have been flattered by effectively borrowing from the future, implying future growth will be impaired despite the popular perception that the past decade has seen unusually weak growth. This clearly has political implications. In the same way as the fortunes of companies can be transformed for the better or worse very rapidly, it is also likely that the relative influence and prosperity of groups within societies and whole countries can change more rapidly that in the past. The authorities in democracies are finding it hard to adapt to the rapidity of change and the structural problems created by high debt and negative demographics. Partly this is because the views of the political establishment and vested interests tend to evolve comparatively slowly and are not suited to deal with issues that require taking a long term view. The continual failure of the UK government to adequately address pensions, social welfare and healthcare spending illustrate this. It therefore seems likely that the western political and monetary authorities are likely to persist with their easy monetary and fiscal policies for as long as they can, implying that the sense of well-being and stability they create comes at a cost of creating larger problems and instability down the line.
There are several secular reasons for the rates of inflation, interest rates and bond yields to remain low, such as ageing demographics, the deflationary impact of high levels of debt, globalisation and the impact of technology. However, high levels of debt are not always deflationary. Learning from the past it can be seen that high debt is often dealt with via financial repression – in other words its value is eroded by interest rates being kept below the rate of inflation for long periods at modest rates, or for shorter periods when the rate of inflation surges and the real value of debt collapses. There are a number of well-regarded commentators who make cogent arguments as to why the current trends of ever rising debts and low rates are unsustainable, and a jump in the rate of inflation is a serious possibility. Clearly, there are very divergent investment ramifications for how bonds and equities perform depending on what happens with inflation and interest rates. However, as it is impossible to forecast the future it is prudent to construct portfolios cognisant of the opposing risks of deflation and much higher inflation.
While real interest rates (i.e. the level of interest rates adjusted for the rate of inflation) are modestly positive in the US, in most developed countries extreme monetary policy has pushed them to negative levels. There is a degree to which real interest rates are the guiding star for all asset prices as they are the most accurate risk-free rate of return, as a positive rate implies investors can easily increase the value of their savings by taking little risk, while a negative rate implies investors will see their investment steadily decline in value taking into account the effect of inflation unless they are prepared to take greater levels of risk. This is why negative real rates have driven most global asset prices higher, as they have encouraged investors to take more risk in a quest to achieve positive real returns. In the long term this creates vulnerabilities as the economy may be undermined by anything that causes a reverse in investors’ appetite to risk, as a sharp drop in asset prices could quickly hit economic activity by shaking consumer and business confidence.
We appear to be in a stage where the promise of accelerated change through technology implied by the TMT boom and bust at the turn of the century is now playing out in reality. This is causing rapid change for good in many areas, and is also accelerating trends towards globalisation in various sectors of business and society. Some areas are being affected profoundly, such as healthcare, entertainment and retail, which is creating outstanding investment opportunities. Inevitably, however technological change creates challenges, and is having negative impacts illustrated by the travails of many traditional ‘bricks and mortar’ retailers.
Globalisation is linked to a trend that is undermining the power of nation states and their governments in favour of other power centres such as leading cities, major corporations with a global reach and self-identifying groups that cross national borders – most notably religious groups of which Islamic State is an extreme example. This trend is likely to build to crunch points that create backlashes. One example, which is likely to have significant investment ramifications, is the negative influence on the tax-take from the rise of the global megacaps (notably the FAANG stocks, with the recent speculation about Amazon facing higher taxes in the UK being an example). We are yet to see a coordinated global response to create the tax and regulatory framework necessary to respond to the business models adopted by many of the fastest growing global companies. This is likely to change over time, and is related to a more general point, namely the fact that corporate margins have in aggregate risen to levels that are likely to come under pressure from various factors, including rising labour costs, higher financing costs and government (i.e. regulation and tax, notwithstanding the recent US tax cuts).
The rapidity of change is creating significant opportunities in many emerging and frontier markets. This is enhancing the relative structural advantages many of these markets enjoy over developed economies, in terms of their more favourable demographics and growth potential. For example, modern technology has enabled some emerging markets to develop comprehensive banking and telephony networks at a pace that would have been unimaginable just a decade ago. Developments relating to corporate governance, monetary policy and fiscal policy vary across emerging and frontier markets. However, across such a large and heterogeneous universe there are on balance reasons for optimism that standards are improving. In the short term the fortunes of many emerging and frontier economies can be volatile, with conditions changing rapidly for the better or worse driven by movements in commodity prices, international investment flows and movements in US interest rates and the value of the US dollar. However, while these create volatility and downside risks, the superior long term growth potential of emerging and frontier markets present very attractive investment opportunities.
A number of these trends have significant implications for the relative strength of currencies. Sharp currency moves are likely to be an on-going feature of the investment environment. The US dollar retains its position as the world’s dominant reserve currency, underpinning its value particularly during periods of nervousness in markets. However, the long term value of the dollar is threatened by the persistence of the large US deficit and the moves by China to find alternatives to the dollar as the global reserve currency. The growth of crypto-currencies further complicates the task of forecasting how the relative value of currencies will move in the future, although we do not believe it threatens the position of gold as the ultimate hard currency. The extraordinary energy demands involved in managing cryptocurrencies seems likely to be an inhibiting factor in their development, particularly as it flies in the face of the increasing acceptance of the need for environmental sustainability. However, blockchain technology, which is integral to the workings of cryptocurrencies, seems certain to have an important future with potential applications in a variety of areas of business and the public sector.
Despite the longevity of healthy financial markets, it appears that quoted public markets are not necessarily the best means for managements to grow businesses. There is a trend for businesses to stay private for longer than in the past, and the flow of companies coming to the market is offset by a high level of merger and acquisition activity, and others being taken back into private hands. They are various reasons behind this, such as the short termism of many institutional investors and directors in publically quoted companies, and unhelpfully complex regulations affecting listed companies. This trend is coinciding with a challenge to the traditional investment management industry from the rapid growth in low-cost passive, and quasi passive investing. Ironically this means the growth of passive investments tracking public market indices is coinciding with a parallel trend of more wealth creation happening in areas of the economy which are very hard to track. The huge amount of cash being funnelled into private equity recognises this. However, with an increasing proportion of that sitting in cash, it shows that making the decision to track a public market index is much easier than seeking to access non-publically quoted wealth creation, which requires experienced managers with good connections to deploy it.
Taken together we believe the above 10 trends suggest asset prices are currently distorted, many in an upwards direction by the policies authorities have adopted in developed economies both before and after the Global Financial Crisis. Nevertheless, while it is right to be concerned, it is also true that there are some hugely positive secular trends in force that it is easy to lose sight of by worrying about the obvious economic challenges and where we are in the cycle. It is impossible to know how long the current equilibrium will last. However, the sheer length of the period of growth in this cycle, and the fact that the US Federal Reserve is leading a tentative reversal in monetary policy, implies the environment is likely to change. Change could be gradual or sudden, but in the light of this we have steadily been making our portfolios more cautious.
How our analysis of these 10 trends has influenced the management of portfolios
The following explains how our thinking about the global investment environment has affected the construction of our portfolios. While these trends affect how we invest for all portfolios, the examples used are from the Hawksmoor Funds.
We have an unconventional approach to investing in bonds given the degree of manipulation of interest rates and the inherently unattractive upside/downside skew of risks versus rewards. Most of the Funds’ bond exposure has little duration and much of it is in a spread of investments in loans linked to specific assets and projects. We also have inflation-linked exposure while avoiding very expensively priced government inflation-linked bonds.
We have been increasingly cautiously positioned recognising that we are moving from a period of persistent monetary and fiscal support for financial assets to times when things are generally becoming more constrictive. We’ve been doing this gradually for some time, and until recently the exceptional performance of a number of our specialist holdings has enabled our Funds’ performance to outpace their respective IA Mixed Investment Sector averages despite their relatively cautious positioning. We have also increased exposure to funds, such as Real Estate Investment Trusts (REITs) invested in attractive niche sectors of the property market, which we believe can deliver dependable annualised returns in high single digits. These returns are likely to prove competitive in an era when most financial assets are highly valued relative to their history, albeit the REITs’ short term performance in general market setbacks can be affected negatively by share prices moving to discounts to their net asset values. We are also seeking to have most of the Funds’ market sensitive exposure with managers who are in tune with our mind-set (i.e. worrying about the downside and having a style that includes avoiding investments that have a risk of permanent destruction of capital).
We have sought to find the best protection we can against an end to the current period of excessive confidence that most investors have in the ability of central banks to control investment markets. If the authorities lose control there could be spikes in the levels of inflation and interest rates, or possibly a deflationary slump causing real rates to spike even lower. This is clearly hard to do in an environment in which assets are generally highly priced, and there is much diminished scope for government bonds to provide diversification benefits in portfolios. We have sought to achieve diversification and protections through exposure to gold, managed futures and absolute return funds. In aggregate, all of these funds have detracted from our Funds’ recent performance. However, while exposure to gold has been a notable detractor from our performance for some time, we continue to believe it has an important place in portfolios by providing exposure to the ultimate hard currency if the authorities’ policies become unsuccessful in maintaining the fragile status quo of rising debt, low inflation and low interest rates.
We are not making asset allocation decisions simply by conventional measures such as by geography and asset class. In other words the trends discussed above make traditional asset allocation decisions much less applicable than in the past. It is no longer sufficient to split up portfolios based on bonds versus equities, or by country, region, sector etc. Instead we are making investment decisions about how the assets are likely to perform based on the influence of trends such as those described above, and how each investment contributes to the resulting structure of the overall portfolio. One good example of how our Funds are different is our consciousness to avoid home-market bias, and holding significant exposure relative to our peers in Asia and Emerging Markets versus the UK. Furthermore, our use of specialist REITs, gold funds, absolute return funds and convertible bond funds illustrate how we have sought to achieve effective diversification at a time when diversifying portfolios through a traditional bond and equity split is no longer adequate.
We have identified numerous specialist investments to play some of the themes referred to above. This has been an important feature of our Funds’ success that we will endeavour to make sure continues. Significant thematic investments include – areas undergoing transformational change (healthcare funds and niche real estate). Exploiting attractive unquoted investments (Private equity and specialist areas such as private debt accessed via listed closed ended funds invested in project finance and real estate and infrastructure debt). The rise of fast-growing-dominant cities (the success of the Funds’ investment in Phoenix Spree Deutschland has been fuelled by Berlin’s growing importance and prosperity).
Rise of passive funds and the ETFs. We have sought to protect our Funds’ portfolios against a disorderly reversal of flows into ETFs by having comparatively little exposure in areas where ETFs have been very influential in driving valuations higher. This includes having cut back exposure to particularly vulnerable areas with comparatively poor liquidity, such as high yield bonds, as outflows from passive investors would be likely to lead to sharp falls in prices and potential difficulty for ETF providers in selling positions. We believe strongly that our chosen active fund managers should be able to add considerable value over the long term, and that an interruption in the trend for rapid growth in ETFs and passive investments could prove very advantageous for their relative performance.
We’ve had a very long period in which companies have had the tail winds of falling financing costs and uninterrupted economic growth. This has helped companies with high levels of debt and has created excellent conditions for investment strategies relying on financial engineering. Going forward we need to be careful about such things, given the potential for economic growth to tail off, bond yields to rise and liquidity in bond markets to deteriorate (as supply rises and demand weakens given changes in QE). This is something we are paying close attention to, causing us to favour funds run by managers who favour companies with strong and/or improving balance sheets. It has also led us to avoid some closed ended funds that rely too much on financial engineering to hit their target returns, and to stick to private equity trusts that have strong balance sheets themselves as well as not chasing deals with increasing levels of leverage.
As it is impossible to predict the future it is an open question if trends in markets are changing and thus whether portfolios that performed best through the period since the Global Financial Crisis ten years ago need to be repositioned. If trends are changing the optimum portfolio for medium to long term performance is likely to perform erratically through a period in which markets are moving from one equilibrium to another. While we don’t predict market moves, we do react to changes in valuations and fundamentals by adjusting portfolios. The steady reduction we have made to mainstream assets and the increasingly idiosyncratic nature of our current portfolios does imply conditions are ripe for change. Nevertheless, patience is required, because it is often the case that prior to decisive turning points valuations move to extremes, and the best investments for the medium to long term underperform ahead of a sudden upturn in their fortunes. We are therefore seeking to carefully judge how to position portfolios in the light of these trends. Our analysis has led us to build exposure to areas where long term valuations look most attractive, even when short term momentum is poor, while always endeavouring to ensure portfolios remain well diversified with a spread of investments suitable for the risk profile and other requirements of the relevant mandate.
This financial promotion is issued by Hawksmoor Fund Managers which is a trading name of Hawksmoor Investment Management (“Hawksmoor”). Hawksmoor is authorised and regulated by the Financial Conduct Authority. Hawksmoor’s registered office is 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. Company Number: 6307442. This document does not constitute an offer or invitation to any person, nor should its content be interpreted as investment or tax advice for which you should consult your financial adviser and/or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. Any opinion expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represents the views of Hawksmoor at the time of preparation. They are subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. HA2737.