21st December 2015
David Jane, co-manager of Miton’s multi-asset fund range, reflects on the investment lessons of the past and what may happen in the future…
At this time of year it is traditional to think about markets in a longer term context, so this week we thought we would reflect on some of the lessons of the past, the present and what might happen in the future.
Investment is a cyclical business and past events tend to repeat themselves but in a slightly different form. As we consider markets today, what are the three key lessons of the past that markets have failed to learn?
1. Liquidity is your friend
Many investors take a simplistic view of risk, thinking about volatility and correlations but ignoring liquidity. History is littered with financial crises which were caused by a mismatch of liquidity, whether it was the many and various hedge funds that have offered monthly dealing but held assets that never or only rarely trade, leading to clients getting ‘gated’ (not able to sell).
Similarly, various property unit trusts had the same experience; clearly investors expect daily dealing but buildings don’t trade daily. These mismatches do not matter until you want to sell, and in the interim, investors think they have a low risk asset because the volatility is low.
At present there are a few areas where liquidity may well become an issue. The one that seems to be a favourite is corporate bonds. High yield corporate bonds have been packaged up in various ways into funds of various kinds, unit trusts, OEICS, US mutual funds and ETFs, all of which have open ended features and therefore liquidity which greatly exceeds that of the underlying assets.
In the US, several bond funds have recently closed as they have suffered redemptions and then found themselves unable to sell their underlying holdings.
Clearly there is a possibility that the troubles of US bond funds escalate and begin to be reflected in the UK and Europe, where many of the same conditions exist. There have been many years of attractive returns, but now returns are not as good. Many funds are showing losses year on year in an area widely thought to be low risk. Given the underlying liquidity of the corporate and high yield bond markets, high levels of redemptions could seem lead to similar problems.
We always manage our portfolios with a high level of liquidity, not just considering the apparent liquidity but the liquidity of the underlying assets and how things might be if we want to sell at the same time as everybody else. For this reason and given the stage of the market cycle, we have been running both our equity and bond portfolios very conservatively, which may mean we have to forego some potentially attractive fixed income opportunities and some potential gains from smaller stocks in equities, but the avoidance of potential future pitfalls remains our key priority.
2. Debt matters
In every cycle it is the leveraged businesses that fail. Those with no or little debt can withstand vastly greater problems than those with debt. Ironically it is often the weaker businesses that resort to debt to improve returns. They are commonly encouraged to do so by shareholders, only to find that when the cycle turns, those fixed liabilities come back to bite them.
The increase in the borrowing costs (reflected in widening high yield credit spreads) for many borrowers in resources, but recently broadening out to industrials and autos, can be a self-fulfilling prophecy as higher borrowing costs weaken the already indebted companies.
After many years of very benign credit conditions, signs of stress are starting to re-emerge. The levels of debt globally have ballooned over the recent past, with many countries, companies and parts of the population taking advantage of this extended period of very low interest rates.
Our picks for potential future problems would include emerging market bonds, where the many countries and businesses have borrowed in dollars, taking advantage of ultra-low rates. The income stream that supports this debt is under pressure from the slowdown in China or falling resources prices, while US rates are beginning to rise and the dollar is strengthening.
Next on the list has to be the western corporate sector, where many borrowers in cyclical industries have supported profits with higher debt levels. The recent failures in US resources are now being joined by other industries and spreading over to Europe where Abengoa in Europe could be the first of many.
Finally, many areas of consumer borrowing are a potential cause for concern, from US auto loans right through to peer to peer lending. Auto lending has supported US car sales which has been a major prop to US growth. Anecdotally, the quality of lending to this area seems to be remarkably poor.
A setback in this area would be a major headwind for the US. In the case of peer to peer, this is an area untested by the economic cycle, which is inevitably a source of concern and no doubt while highly disruptive to existing lenders, it is a rule of thumb in banking that the new entrant ends up with the lowest quality loans.
By avoiding these areas we clearly forego some attractive near term yields, but we feel the potential for medium term losses is becoming great.
3. Things can change very quickly
In every cycle, things which seem inconceivable one week become normal shortly afterwards. Whether it was the demise of the mainframe computer industry in the late 1980’s, the collapse of the banking and insurance industry during the Global Financial Crisis or the Asian crisis in the 1990’s, whole sectors can go from stock market darling to pariah in short order.
So clinging to a belief set too rigidly can be a huge mistake.
Clearly, the rapidity of the recent unravelling of the resources sector and its consequences for bond markets and equity dividends has caught many by surprise. Previously large and seemingly well-capitalised companies have found themselves as forced sellers of assets and beholden to bond holders.
In some ways the Volkswagen emissions crisis has similar characteristics. What was previously a well-respected business has found itself in turmoil, exacerbated by a heavily indebted balance sheet.
The pace of disruption in a whole range of industries appears to be increasing as the pace of technological change increases.
For this reason, whilst we are intrigued by the opportunities this throws up to invest in new businesses, we are alive to the possibility that existing businesses can find their customers moving to a new competitor much more quickly than before.
The same goes for financial markets. Historically a new trend might take several years to play out. Today with information so widely available, markets can turn very quickly.
For these reasons we think flexibility is the key, with the ability to move our portfolios between asset classes and across sectors within an asset class quickly.
What was the most attractive source of income and growth a few years back can become a no-go area in short order, so we take an unconstrained approach to all our strategies, being prepared to move rapidly between asset classes as conditions change.
As we go into 2016, we think these lessons of the past will be particularly important as the outlook is less clear than it has been for some time.
The QE era is coming to an end and there are many signs of a slowdown. In order to protect capital and generate income we think avoiding the three perils of illiquidity, excessive debt and failure to recognise rapid changes will be critical.