Bridge over troubled water
Many opportunities exist for the patient investor, says Thomas Becket, Chief Investment Officer, PSigma Investment Management…
We have just suffered the worst quarter for financial markets since 1928. Confidence is very low and markets are almost totally focussed on what might go wrong for the global economy.
The press and media certainly seem obsessed with trying to discover what the worst case scenario is for the global economy and financial markets. Whilst we are respectful of the downside pressures that remain for financial markets, we also believe that it is sensible to have a more balanced view of what might happen in the quarters and years ahead.
In this latest newsletter we will discuss the miserable summer months, the ongoing uncertainty and, perhaps most importantly, focus on some of the investment ideas that we believe can help to generate positive returns in the years ahead. It is certainly a time of caution, but it is also potentially a time of great opportunity and investors would do well not to be totally overcome by the Bull Market of pessimism that has swamped financial markets.
Let us deal with the worst case scenario first. If there is no decisive resolution to the European debt debacle, there is a chance that the corporate sector will suffer from a lack of working credit from the pressurised banking system, probably ensuring that the economy plummets in to another recession; meaning that investors run for cover and global markets will probably fall as precipitously as they did in late 2008. At this point in time, we do not see this “doomsday” scenario as a “central” case, but we have to be respectful of the fact that it is a possibility and we are aware of the wealth destruction that would accompany this scenario.
We have to acknowledge that Europe remains a total mess, but at least the leaders of the various factions that have developed within Europe have now all agreed on the desperate nature of the situation at hand. Bridges are now being built rather than being burned. Markets have stabilised and moved higher in recent weeks to reflect the improvement in the political understanding of the grave nature of recent events. If only they could have arrived at this point six months ago! For our part, we expect systemic recapitalisation of the European banking system and a huge buying programme of European bonds. Maybe it won’t be the “bazooka” that David Cameron has called for in recent days, but it should be enough to restore some semblance of calm and confidence to Europe, if only temporarily. At the moment the market is infatuated with a Greek default and this is the fault of dallying and indecisive politicians. Our view is that they should allow Greece a huge “debt forgiveness” of about half of its debt, allow the country to rebuild and try to isolate the problems in the wider banking system. Perversely we think a Greek default might actually be a positive spur for markets because at least then the lingering and boring uncertainty will have gone. It is not a great stretch of the imagination to find a way to “ring-fence” the Greek issue, but it needs to be done soon, so we can move on and confidence can return to corporate management, consumers and investors.
It is of course confidence that is truly lacking throughout the global economy at this time. It is not just Europe and its troubled banks that have hit sentiment hard, but also fears over a global recession and (most recently) a hard landing in China. A miserable “triple whammy” if ever there was one, all of which have created the extreme and unprecedented volatility that ruined the summer months. With regards to global economic data, we would be hard pressed to find examples of rampant global growth. However, on the flip side, it is also hard to find many examples of the world crashing in to a full-blown recession. Indeed in recent weeks the economic data out of the US, Japan and the UK has been suggestive of a global economy that has once again started to pick up pace after an extremely lacklustre six months. European economic data remains insipid at best, but again this is not yet a 2008 scenario.
When it comes to China and the Emerging Market economies, there are clear signs that the interest rate rises of the last 18 months have started to bite, impairing growth rates and curtailing consumption, but also containing inflationary pressures. This latter point should be seen as a positive, as a cooling in inflation would allow the EM central banks scope to start cutting interest rates, as we have seen from Brazil over the last month. It would be naïve to suggest that there are not risks to growth within the EM economies if a recession eventuates in the developed world, but these economies remain in a healthy state and should lead to investment opportunities over the next few years.
Clearly with the pressures existent in Europe and other parts of the world it is not a time to be “gung-ho” in our investment strategies. However, contrary to most other commentators, we do believe that it is right to examine what might go right, as well as what might go wrong. If any of the problems cited above start to dissipate, or the world is not in so bad a state as many are suggesting, then financial markets are presenting some excellent opportunities that we are trying to take advantage of. Admittedly, one might have to stomach wild volatility and periods of weak performance, but the potential rewards on offer from certain areas of credit and equity markets are very attractive. As an example, the FTSE 100 is trading on a prospective Price to Earnings multiple (P/E) of 9x next year's earnings. Even if analysts are characteristically wrong by (say) 20%, this leaves equity valuations at least undemanding and arguably very cheap. The same is applicable to many other global equity markets, including Europe, where equity valuations are now approaching the trough multiples seen in March 2009, even accounting for potentially erroneous analyst expectations. Indeed in the US, the equity risk premium (how much investors are compensated for holding “risky” equities over “safe” bonds) over US Treasuries is now at levels not seen since the 1930s. History has taught us that the best time to buy quality companies is when markets start to move into a state of panic. Strong and attractive businesses can be bought "on the cheap" and now is potentially such a time. It is important as long term investors that we sift through the rubble created by the recent market crash and try to exploit opportunities in the volatility.
At times of extreme financial market stress, we believe it is important to take a step back from the short term chaos and focus on the investments that we want to make for our clients with a ten year time horizon. Whilst predicting short term market oscillations is increasingly a 'mug's game', we believe that we can find a number of attractive and potentially powerful trades that will drive returns for the next decade.
Striving to find inflation-protection within portfolios will be absolutely vital for the next 10 years. Our expectation is that inflation will fall next year, panicking the Central Bankers into pressing the big red button on the printing presses, as we saw the Bank of England do last week. This could send inflation in the future into 'hyperdrive', potentially creating the 'Great Inflation', which will drive investment returns later in the decade. Sadly, 'inflation insurance' is now very expensive, particularly in government index-lined bond markets. We therefore favour the innovative M&G Corporate Index-Linked Bond fund. By using this fund one not only gets an attractive diversification to a number of high quality global corporate issuers, but one also receives a coupon in excess of 1% higher than government equivalents.
We also believe that high yield corporate bonds will be an important investment within our portfolios. In the next few uncertain years it could well actually be a more successful strategy to be a “lender to” than an “owner of” companies. Most companies have re-financed at attractive rates, so defaults should not be an issue, unless the world does collapse in to recession. In our central case of low but positive economic growth, we believe that the strength of corporate balance sheets and ridiculously low government bond yields/ interest rates will be supportive of high yield credit returns. We know that many investors are desperate for income and after the recent sell-off, we believe that you could generate a 9% return per annum from high yield credit, with significantly less volatility than equities. With opportunities such as this, it is hard to become overly-pessimistic.
We also recognise that in the coming years we are going to see a race between the global ‘Big Four', (US, Japan, Europe and the UK), to devalue their currencies as much as possible, so that they can try to revive their flagging manufacturing/ export sectors. Currency debasement will make investing in foreign exchange markets extremely challenging. However, one region where we do have confidence is Asia. Strong government balance sheets, elevated rates to combat inflation and an increasing financial influence over the world should see Asian currencies rise against their beleaguered developed world cousins in the next decade. Our favoured way of gaining exposure is through the Aberdeen Short Duration Asian Bond fund. We feel that with the 3.1% coupon from the bonds it invests in, which perversely is significantly higher than equivalent bonds in the debt-ridden mature world, you could earn returns of 7-8% per annum over the next 5 years, as Asian currencies appreciate.
Things might well get worse before they get better, but we believe that the world has become obsessed with trying to pinpoint the next crisis, rather than focusing on valuations and long term opportunities. None of the global economy, banking system or corporate sector is in fantastic shape, but they are all in a satisfactory health and as long as politicians and investors don’t completely “throw the towel in”, then we can avoid the widely-prophesised recession and have some hope for the future.
Hopefully we have highlighted some of the opportunities that are on offer to investors and it is important after a chastening quarter to focus on the future rather than the past. If the Europeans manage to build a stable bridge over the troubled water, then we can return to the healthy trend of rising markets that we have enjoyed over the last few years. We are hopeful that a more optimistic outlook might evolve with the imminent start of the corporate reporting season where we will get fresh evidence on how the corporate sector is actually performing amidst the pervading gloomy macro newsflow. However, we stand ready to change strategy should we get confirmation that the press and media are right and a swingeing recession is on its way.
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