Q2 2019 Overview
To repeat Warren Buffet’s famous phrase, it is only when the tide goes out you see who has been swimming naked. One of the more interesting developments of the last few months is that a couple of high-profile investors have been caught without trunks on, even in what has been a very benign, rising tide market. The most prominent of these was, of course, Neil Woodford. At his peak he was running over £10bn with up to £1bn in illiquid, unlisted equities. When performance turned down, redemptions began, and it was the liquid, easier to sell assets that were sold first. As redemptions continued, so the illiquid part became a larger and larger part of the fund and, eventually, Woodford was forced to suspend redemptions to stay within regulatory liquidity limits. To stop the same thing happening when the fund re-opens we think nearly all of the illiquid holdings will need to be sold. This will require patience to get the right price so we are not surprised the fund has continued the suspension for another month. Longer term investors should be able to ride all this out, but even they will suffer a loss of returns from having to endure a fire sale of the illiquid positions.
A couple of comments on this that are relevant for us. First, our research team and investment process have a clear focus on making sure illiquid assets do not form a significant part of the liquid funds we invest in. This was one reason we avoided the Woodford mess. Before we get too complacent, however, you should note that all funds necessarily pool a variety of investors together. This means that we are always exposed to the vagaries of other investors buying or selling in large amounts and so affecting pricing or fund liquidity. Occasionally (though very rarely in reality) suspensions happen for funds and one day this may happen to us. Given we and our clients are longer term investors and we limit the size we have in each fund we own this should not pose any material longer term issues.
We do, however, always look to minimise this risk when it looks to be a clear and present danger. The best example of this today is UK commercial property funds for retail investors. These offer daily liquidity despite owning physical property and we have owned them as a flexible way to give clients some physical commercial property exposure. The sizable cash buffers these funds hold are designed to cover any short term liquidity issues. That said, we all know Brexit remains front and centre for UK politics. We will see whether Boris Johnson keeps his promise to leave by the 31st October should he become the next UK prime minister, but the likelihood of a no-deal Brexit has certainly been rising (see Chart 1 put together by Bank of England). If this happens, we would expect UK property funds to suspend temporarily. This is because in the event of any large shock to markets there would be short term uncertainty over property prices. The current advice of the FCA is that if this happens property funds should suspend until the valuation picture is clearer and a fair price can be given to investors both entering and exiting the fund. With no deal risk up above 30% this is an inconvenience we are happy to avoid for the sake of a few months returns. We still think commercial property is a good diversifying asset for clients and we will look to re-enter these vehicles when the Brexit endgame is clearer. For now, though, we are happy to wait the process out by holding more liquid sterling corporate bonds.
Outlook for the rest of 2019
On the face of it, the year so far has seen a healthy recovery from the sharp fourth quarter sell-off in equity markets. As we wrote at the time, markets were reacting to worries that the recent interest rate rises from the US Fed might trigger a global slowdown and recession. Does this mean that Q4 was a false alarm and we can sound the all clear for the global economy? Unfortunately, the answer is no. Although equity markets have rallied, this has been driven by defensive and some growth sectors (i.e. the best places to be if a recession comes). Cyclical companies most exposed to recession risks have continued to under-perform.
More alarmingly, longer term interest rates have continued to fall. One way to think of the 10 year interest rate is it is the average of short term deposit rates for the next 10 years plus a bit to compensate you for the risk of locking into low interest rates should inflation come along again. As I write the 10 year interest rate in the UK is 0.67%. This is below today’s base rate of 0.75%. The market is telling you that the Bank of England will cut rates at some point over the next 10 years and will then never raise them again. Think about the outlook for growth and inflation if the bond market is right! The market is also telling you not to worry about inflation ever again. Instead the risks are Japan style structural lower growth and deflation. And this is not just a Brexit driven UK story, bond yields across the world are telling the same story. US 10 year yields sit below today’s base rates and German 10 year yields are, almost unbelievably, -0.40% per annum. Yes, your reward for lending to the German government for the next 10 years is to get back 4% less than you lent them in the first place with no interest payments at all along the way.
How do we reconcile this with US stock markets at all-time highs? First, there is optimism that the Fed will cut rates in July and again later in the year and this will be enough to keep the economy growing. We think the data will need to turn more positive pretty quickly for this optimism to stay in place. Survey data, which does a good job of predicting the short term direction of the economy, is still pointing down (Chart 2). Adding to this the on, off and on again nature of the US/China trade wars is hurting business sentiment and investment plans (see Chart 3). We see US/China tensions as being a structural feature of markets now rather than something to lay all at the feet of Donald Trump. Playing tough with China is good politics for both Republicans and Democrats.
As long as this slowdown remains in place our risk levels will remain at neutral. We are reluctant to be underweight risk today as this is a world where central banks look to be able to cut rates without the risk of raising current or future inflation. It is inflation, and the higher rates that eventually will come along with it, that we think will ultimately threaten today’s asset price levels. Otherwise, in a world of structurally low interest rates the current yields on equities and property, for example, still look attractive. Of course, many markets (including property) do look expensive by historic standards. But many – including emerging markets and more domestic focussed UK companies – look well priced today even when compared to historic valuation levels that occurred when yields of 5%, say, on cash were easily available. These assets look well placed to deliver the 7% to 10% annual returns for investors they have generated historically. We are therefore maintaining our overweights to some of the more cyclical opportunities in our portfolio. Even though we know the journey will be volatile, we want to own these assets today to make sure you achieve those returns over the next decade.
Environmental, Social and Governance (ESG) investing
Finally, a note on some developments that are happening in ESG investing. The area continues to grow and the range of options that are open to us in this space are always increasing. The traditional approach is (as happens today) your money is invested responsibly in the broadest range of assets available and then it is up to you how much of your wealth you then choose to allocate to environmental projects and worthy causes. Increasingly, though, there is demand for the inclusion of ESG principles into investment portfolios themselves. This can range from screening out companies that are deemed “bad” for society (such as tobacco companies and some arms manufacturers), to favouring companies that are on the right side of environmental issues and climate change (such as the solar and wind farms we invest in today), to investing in projects that are designed to improve the world and accepting a lower return along the way (e.g. micro-lending to the very poorest).
Over the next few months we will be putting together ESG versions of our traditional portfolios. If you have interest in this area and/or think you might want to include some ESG into your current investment portfolios then please get in touch and, when we have finalised our offering, we will be happy to discuss it in more detail with you.