Even after the latest act of the Greek tragedy, equity markets are still showing solid gains for the year. Global equities (measured by the MSCI World total return index) are up +4% in sterling terms as we write. The UK, having lagged in 2014 is today +5.6%. 2015 is now turning into the fourth year of an equity market rally that has been surprisingly calm: the MSCI World total return has been positive in sterling terms for the last 11 quarters in a row. Our client’s equity portfolios have generally beaten both these benchmarks but after any run of good performance we slowly become more nervous. Is this the calm before an oncoming storm? We are not that bearish but we do think the market is overdue a healthy shake out.
Our thoughts are therefore concentrated on ways to make money outside of equities. This is always a focus for us because of our multi-asset approach but seems more important than ever today. The traditional diversification vehicle for asset managers has been fixed income. However, as we wrote in our last IPS View (No one remembers the 1970s) on some measures, government bond markets are now riskier than equities. There are also good arguments that equity markets at their current levels are only really attractive when compared to ultra-expensive bonds. As interest rates slowly rise, bond prices fall and they slowly become more attractive relative to equities. We have seen the first half of this happen in the last few weeks: UK 10 year interest rates have risen over 0.7% from their lows causing a loss of around -4.5% on UK government bonds for the quarter. What if this triggers a re-pricing in equity markets?
On one level, this would be a tough environment for all long biased investors, including IPS. We can, however, work hard to make sure that our choices of diversifying assets are not exactly ones triggering equity market losses. This therefore rules out much of traditional fixed income for us. Where else are we looking for alternative sources of return? Right now we would divide it into two broad camps: first property in general and residential mortgages in particular and secondly trading investments that do not rely on today’s high starting values to make money.
The attractions of residential mortgages are threefold. First they rely on steady economic growth to keep mortgage payers in employment. Secondly, they are floating rate. Third, though rising rates will cause some repayment shock for borrowers we think central bankers will raise rates gently over the next few years and certainly not fast enough to cause real pain in the consumer sector. If you think the economic upswing has further to run (as we do) then this leaves an attractive alternative source of income to traditional fixed income which can be accessed in the US and UK. Finally, the fact that the sector was front and the centre in the 2008 financial crisis means we think it will be slower to overheat again this time round. Certainly we don’t see any of the excesses of 2006 reappearing in the market today.
Commercial property also retains its attraction. Rents should generally be expected to rise with inflation so in that sense the income stream from them is similar to that from long dated inflation-linked government bonds. The current rental yield on the UK IPD commercial property index is 5.2%. Compare this to the current yield on longer dated UK index-linked gilts of around 0.25%. Even after fees and lower liquidity is taken into account we would still rather own property.
As for investments that do not depend on today’s valuations to make money, we would highlight two. First, in equity markets, we hold investments in funds that are, in the jargon, market neutral. This means that the fund makes money only if the manager’s stock picks beat the market. The direction of equity markets should, in theory, make little difference. We are investing in the abilities of the manager, not in the direction of the market. Secondly, we are maintaining our holdings in trend following funds. These focus on all liquid markets (including currencies, interest rates and commodities as well as equities) and simply need steady trends (up or down) in a few of them to make money. In the past 12 months they have profited from both a rising US dollar and falling interest rates in Germany. They also have the added comfort of having made strong gains in previous equity sell-offs (including 2008 and 2011). Crucially, they are relatively agnostic to the starting price of investment markets (cheap or expensive), they just need sizeable moves up or down to make money. If you think volatility is poised to rise, as we do, then they should be an attractive place to be.