Updated: May 25, 2022
All three of our funds have been blowing passive multi-asset funds out of the water based on volatility adjusted returns for five years now and even more so over three years (see Table 1). Importantly, the bond bear market that could crucify these passives and their high fixed allocations to investment grade bonds may only just be getting started.
"Those who have sold equities have been quick to realise their error"
I’m certainly now pleased with our past performance as well as very much excited about the future. And I implore those with exposure to a bond bear market that could last for the next 20 years to reconsider.
2017 was very good to us and thus to our customers. Not only did equities and other risky assets generally perform well, but our investment performance in relation to markets was also good (see attribution tables).
Both our OEICs finished in the top ten in their respective sectors for the year (the income fund was 8th of 147 and the growth fund 7th of 143), while our investment trust, in a slightly more eclectic sector, finished 3rd of 13 (NAV based). As long-term investors, we do not target 12-month performance, but the long term is made up of short terms, so we expect shorter term performance to be good more often than not.
This bull market has been called ‘the most hated ever’. We have never considered it so. I suspect the principal reason many have hated it is because they anticipated its demise prematurely. Whether it was QE, the feeble economic recovery, the belief that the problems in the financial sector that caused the downturn in 2008 still lurked just beneath the surface, or the increasingly popular notion that secular stagnation had set in, there were plenty of reasons to be nervous and uncertain.
But central banks have been very aware of this nervousness and its impact on economic confidence, and have been operating very loose monetary policies. It is these loose monetary policies that have supported economies and thus equity markets in recent years and continue to support them; with negative real deposit rates, why would you want to hold cash? Those who have sold equities have been quick to realise their error, or indeed quick to blame it on the bull market being generally despised (it is human nature to pass the buck).
2017 has thus seen markets continue to be supported by ultra-loose monetary policy. Furthermore, this ultra-loose monetary policy seems to have finally resulted in the global economy reaching escape velocity. Unemployment has fallen to very low levels over the last several years, while inflation is now either out of the danger zone or causing monetary authorities to ease off on their largesse.
We’ve been decently positioned in equities and other growth assets such as high yield bonds, loans, REITs and infrastructure funds. And the economic recovery has hit safe haven bonds where we have no exposure. We also tend to have relatively low foreign currency exposure, believing over time that it adds lots of volatility but not much return. So the sterling strength this year has also helped, at least relative to peers.
At a holding level, our funds have benefitted from a general mid cap focus in the UK, as well as from the good performance of a number of our chosen mid-caps. And as you can see from the attribution tables, selection elsewhere has been good too.
All in all, therefore, 2017 was a good year, which probably means 2018 will be challenging. And this brings us nicely onto the outlook.
My asset allocation framework is based on business cycle analysis. Asset classes tend to behave differently in each phase of the business cycle, so if you can determine where you are in the cycle, you can add value from asset allocation.
Key developed economies are either now in expansion phase (US and UK) or still in recovery phase (Europe and Japan). The expansion phase is evidenced by unemployment having fallen to low levels and inflation hitting levels that require central banks to start tightening monetary policy. The phase behind the expansion phase is called the recovery phase, where employment conditions and inflation are improving but are still weak, and thus where economies still require a great deal of central bank support.
My belief is that 2018 will see key developed economies progressing further along the business cycle and thus towards the point at which monetary policy becomes tight. This will be when a global downturn becomes a real possibility.
When do I think we will reach this point? Probably sometime in 2020, so we have a little way to go yet. In the meantime, though, I expect returns from equities and other risky assets to fall, albeit remain positive. We have already been reducing our equity weights and will continue to do so, with the expectation that we will be materially underweight by the time the next bear market starts in or around 2019, in anticipation of the aforementioned economic downturn that will begin in 2020.
There isn’t a great deal of science behind these predictions. I could be wrong by a year or more. But with asset allocation it is not so much about the ‘when’ as the ‘what’. And I’m not going to wait until the end of the cycle to reduce risk – this would be like braking when you get to the bend rather than gradually as you approach it.
I know that many see quantitative easing as the sickness rather than the cure. Not I. True, the global economic recovery has been slow and at times elusive, but this is as much about the severity of the 2008 downturn as it is about underlying structural problems. A nasty accident necessitates a longer recovery time and much care and attention. QE is simply what central banks must do when interest rates hit zero – they have no choice. In other words, negative real interest rates do not portend a bleak future, but are what is required to get growth going and thus secure a bright future.
The same goes for the other factors that have caused the concern. It was US economist Alvin Hansen who coined the term ‘secular stagnation’ in 1938 in response to two very nasty recessions. It wasn’t that long after that the world embarked on a multi-decade period of high, silicon-induced growth. Consider all the amazing technologies hitting the headlines, and you may conclude as I have there may just possibly be a bright long-term future ahead.
Published in Investment Letter, January 2018
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.