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Mixed Messages

10th November 2023

The UK National Lottery was launched in 1994 with the drawing of the balls back then commanding a prime-time Saturday night TV slot and incorporating a bizarre contribution from ‘Mystic Meg’ who through the power of astrology sought to predict facts about the winner to be. Unfortunately here at Hawksmoor we are not in possession of a crystal ball and tend to sympathise with the Yogi Berra view of the world that “it’s tough to make predictions, especially about the future”. Whilst it doesn’t have the same pithy ring to it, we’d be inclined to go one step further and argue this is particularly the case when it comes to hard-to-forecast macro variables. As a recent case in point, if the modelling work of the army of PhDs working at the US Federal Reserve were unable to spot that inflation in 2021 might not be ‘transitory’, then what chance us mere mortals?

At the heart of our investment philosophy lies the importance of humility and a focus on trying to ensure we don’t step outside of our circle of competence. With no Mystic Meg in the team we accept that we have no edge in economic forecasting and as a result spend little time reading the macro runes. We do however spend a good deal of time thinking about what asset prices across different markets are saying about the future and think deeply about the sorts of scenarios prevailing valuations might be discounting. As multi-asset investors with a broad investment universe, it’s often possible to spot anomalous pricing where one market might be discounting a more negative economic outcome than another. Needless to say, we always look to deploy risk in investments where we think we are being over compensated for the potential risks involved versus those where risks are less well reflected.

A good example at the moment is the mixed messages inferred from the valuations of UK equities and high yield credit where the former appears to be pricing in a fall in earnings consistent with a material economic contraction and the latter something far more benign. The cheapness of the UK equity market relative to its own history and global indices is well known and is in part explained by the evolution of relative sector exposures, but importantly still looks exceedingly good value on a sector neutral basis. Value at the headline index level is a good starting point but we like to get more granular and interrogate the value within the underlying portfolios we own. Given lots of metrics here are forward looking, this includes an assessment of what valuations might look like in different future scenarios. Taking one of our actively managed UK equity funds as an example, its portfolio could experience a 30% cut in earnings – a drawdown consistent with a deep recession – and the Price-to-Earnings multiple would still be some 20% below the long-term average. This is what we mean by margin of safety and being adequately compensated for risk and is why we continue to run with a significant allocation to UK equities.

In contrast, high yield credit spreads at around 450bps are currently trading close to long-run averages. While the quality of the junk bond market has improved over the years (greater proportion in BB), this still seems strange given the considerable macro risks on the horizon, not least those associated with the lagged impact of rapid rate hikes and the implications that has regarding the refinancing capabilities of sub-investment grade issuers. Incorporating credit’s hard to observe illiquidity premium, and current high yield spreads imply that defaults will remain below the 2% mark which is far lower than the typical rate experienced in economic contractions. The further you go down the credit quality spectrum the more complacent the market appears. Whilst certain active managers might be able to exploit the market’s high levels of valuation dispersion, relatively tight spreads at the index level mean high yield credit currently offers a negatively asymmetric return profile where the potential downside in an adverse scenario is greater than the potential upside in a benign one. Against this relative valuation backdrop, we have been materially reducing our exposure to the asset class.

As unconstrained, benchmark agnostic investors, we are able to zero weight markets where valuations are not adequately compensating us for the risks involved and to take conviction positions in those that are. Investing is, of course, an inherently complex business where return outcomes are often reliant on what the hard-to-predict future holds. We would much rather mitigate this complexity and manage the positioning of our Funds based on an analysis of what prices are saying about the future as opposed to trying to guess how that future eventually plays out. 

Ben Mackie – Fund Manager

For professional advisers only. This article 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 and may be 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. FPC1330.

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