EquitiesNov 23 2016

Looking beyond the traditional paradigm

Supported by
Adviser.Advantage
twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Supported by
Adviser.Advantage
Looking beyond the traditional paradigm

Traditional assets have come under pressure over the past two months. What has been most stark about this performance is that there has been nowhere to hide, with bonds selling off at the same time as equities. We would argue that this trend is symptomatic of both asset classes being bid up to extreme valuations. 

The game is by no means up for investors, but we believe it is imperative they cast the net wider to encompass assets that can offer attractive returns and have helpful catalysts to unlock the return potential implicit in a cheap valuation.

Investing does not come with a crystal ball so making cast-iron predictions is a fool’s folly. However, we believe we can stack the odds of making attractive returns firmly in our clients’ favour by owning a select blend of sectors and asset classes.

Our investment process begins by looking at valuations. We believe that future returns will be driven by the valuation one pays for an asset and the level of economic growth it is exposed to. Traditional assets (that is, sovereign bonds and global developed equities) are expensive and growth rates are low. It follows that future returns are therefore lower and have more risk involved (since investors do not have the safety net of having bought something cheap in the first place). 

The chart below indicates that traditional bonds and equities are at their most expensive level for more than 200 years. This contrasts with a low point in valuations, which has been the kindling beneath the fire of asset returns for the past 35 years.

Without getting too bogged down in theory, the bumper returns investors have enjoyed by just owning a simple 60/40 mix (with 60 being the  percentage in equities) cannot go on forever. This mix has yielded a return of nearly 8.5 per cent a year for the past 35 years against a backdrop of a 2.6 per cent inflation rate.

Added to expensive valuations is the breakdown in traditional relationships between these assets. Over the past month, we have seen bonds moving in the same direction as equities (correlations are higher than they were in the taper tantrum of 2013). This means there is no natural protection for portfolios and diversification gets replaced by what we call di-worse-ification.

Our approach is to focus on those assets with cheaper valuations (that offer an attractive upside) and assets that have a supportive tailwind in the form of a helpful business cycle. Infrastructure investments are one such example. While these assets are not extremely cheap, they offer a high and stable yield. They should also benefit from the likely pick-up in spending by governments. Furthermore, the regulated nature of many of these assets makes it easier to pass through inflationary price rises. 

Monetary policy has been the go-to tool to stimulate growth and inflation since the depths of the crisis in 2009. While the world would no doubt be in a worse place had there been no monetary response from central bankers, it has doubtlessly become less effective at each turn and raised valuations of traditional assets to ever more eye-wateringly high levels.

It is nigh on impossible to argue government bonds are good value when more than $10 trillion of them (circa 30 per cent of the market) trade with a negative yield. Monetary policy’s race has very much been run. Governments are waking up to the idea that it is time for them to grab the baton and use low, or (even better) negative yields to borrow money and invest.

Austerity politics appears to be on the way out. In Japan, we have recently seen the approval of $132bn of fiscal measures put forward by prime minister Shinzo Abe. China is already well under way and the US and the UK appear to be turning a corner. New chancellor Philip Hammond has said he will move away from George Osborne’s austerity with a stimulus package put forward in the autumn statement this month.

These measures would boost spending expectations, which are already high. Developed market spending is set to double in the next 15 years and developing economy spending is set to almost triple. Much of this spend will likely be on transportation and other things that drive growth: roads, rail, schools and housing to name but a few. 

While infrastructure is a theme that can benefit from helpful policy, there are also parts of the market tilted more towards value that can benefit from having a margin of safety implicit in their valuation. Examples would be European and Japanese equities.

Both these markets are trading at significant discounts to the US market (which counts for circa 60 per cent of the global equity market and hence swamps returns if one invests globally), have companies that are growing margins and delivering earnings growth.

These value types of equity markets should also perform better in an environment when interest rates are rising. Although this may well be a long way off in the UK (due to the Brexit-induced slowdown), it is expected in the United States. 

Donald Trump’s presidency might have rattled markets and delay that somewhat, but it is likely that the future path is upwards. The table below indicates the outperformance of value stocks in such an environment. 

While this relates to equities, it also rings true for investments in bonds, with expensive sovereigns (the darlings of the past 35 years) under the most pressure. Within fixed income, we advocate allocating to smaller companies that are less susceptible to the forces of rising interest rates (and the negative effect this has on bonds).

Furthermore, smaller corporations in Europe – one of our preferred regions – are much less exposed to passive buying and the distortions this sort of ownership can create in times of stress. Smaller European corporates and asset backed securities offer a healthy yield (approximately 6 per cent), which provides an attractive return and a healthy cushion should markets sell off. 

I would finish by drawing a distinction between assets that are priced to perfection and those that have a margin of safety built into what can be viewed as historically cheap valuations.

Solely investing in traditional assets is a game that is long in the tooth and has grave risks of not providing protection or diversification from unforeseen events. 

We advocate protection through both cheaper valuations but also portfolio construction that involves dynamic asset allocation and owning a much broader swathe of assets than has traditionally been the norm.

 

Rory McPherson is head of investment strategy at Psigma

Key points

There has been nowhere to hide in recent months using traditional assets, with bonds selling off at the same time as equities.

The bumper returns investors have enjoyed by just owning a simple 60/40 mix (with 60 being the  percentage in equities) cannot go on forever.

Infrastructure is a theme that can benefit from helpful policy.