China – The dragon roars into life
In September 2014 (Issue 359), I advised readers to ignore the GDP numbers for China and trust the consumer boom then taking off. Since then, the GDP numbers have got steadily weaker, leading to plenty of bearish comment on the stock market. But, as I said at the time, if consumer spending and wages are both rising at 10-15% annually while inflation is under 5%, why wouldn’t you invest? A return of over 40% since then is good enough, but my feeling is there could be a lot more to come.
Since last Autumn, the Chinese themselves have started to pile into the market in a major way. Obviously, the main reason is that they can’t make easy money in property any more. Property prices continue to slide gently, but with no sign of a crash. So new brokerage accounts have been opened at record rates and prices of small domestic stocks have soared. Whether such stocks are sensibly priced on PERs of 30 to 50 is debatable, but a well-run business ought to be able to raise profits at a much faster rate than 15% if that is the average growth in consumer spending. This isn’t a scenario that lends itself to analysis using the “secular stagnation” models of Western analysts.
Central bank maintains control
The central bank seems to have learnt its lesson from last time around, when a vast wave of liquidity and investment spending created all sorts of problems including much bad lending. Having tightened monetary policy by raising rates, it is now easing policy not with rate cuts but by reducing the size of the deposits commercial banks have to keep at the central bank. At the same time, central government is starting on plans to consolidate and tidy up local authority debts, while state owned enterprises (SOEs) are under pressure to become efficient and earn a return on their capital. All this is positive for the long term, so the drop in investment that is causing the decline in the GDP growth rate is, to my mind, almost irrelevant.
Go wild, go East
Naturally, a market like China is likely to have Wild East qualities for a long time to come. It’s probably best to think of it as like Wall Street in the 1920s. Individual investors will probably trade with greater and greater leverage as the market climbs. There is a serious risk of sudden shocks and market plunges. But these are, I think, likely to be short-term so long as that consumer boom continues. The reason is simple: if a stock is overpriced on a PER of 50, it takes only two years of earnings growth at 15% to reduce the PER to 22.
There is no doubt the domestic market is getting speculative. The Shanghai index is up 107% in 6 months and 144% over a year, as against 46% and 61% respectively for the MSCI China index and 31% and 44% respectively for the Hang Seng index. But the Chinese are the greatest gamblers in the world and have only just started to party. The local index, which carries less weight of boring behemoth SOEs than the MSCI index, could easily double again over the next couple of years.
Fidelity Special Situations Investment Trust, my major holding, is up 43% from last October and 69% since last May. Jupiter China, the best of its OEIC rivals, is some way behind as the chart shows. Fidelity has benefited from its gearing and so long as the bull market continues will go on doing so. Taking into account gearing of 26% and a current discount to NAV of 13%, it looks the obvious fund to buy as compared with ungeared OEICs.
Chris Gilchrist, May 2015
Why the barbell approach makes sense for funds
Most fund managers I meet have pretty conventional views, and some just about justify their fees through skill and diligence in stock selection. It’s rare to meet one who makes you think again.
One such is Chris Burvill, manager of the Henderson Cautious Managed Fund, a plain vanilla lower-risk vehicle that can invest a maximum of 60% of assets in shares but more usually has a roughly 50-50 bond-equity split. He’s been managing the fund since 2003. I met him recently and he explained why he thinks a barbell approach – holding both low-risk and higher-risk assets but nothing in the middle – can make sense.
On conventional valuation metrics, especially relative yields on gilts and equities, UK equities are cheap. On CAPE and book ratios they are pretty much in the middle of their historical range. Granted, short-term corporate earnings prospects aren’t great, but you can argue that they are improving. So on valuation grounds, equities are still the asset of choice.
For bonds, it clearly makes no sense to buy government bonds (for example German bunds) at zero or negative yields. This is a madhouse created by the European Central Bank’s QE. Does it make sense to buy 10-year gilts yielding 2.4% when the Bank of England’s mandate remains 2% inflation and its Governor says he can see that being attained next year? Only if you play the safety card and say that – as in 2008 – gilts will be the investment of last resort when we have another crisis.
Beware the greater fool
Note that this is just another variation on “greater fool” theory – “I know I’m foolish to buy this investment at this price but there are bigger fools than me who will pay even more for it”. This may be a viable tactic for short-term traders but is not something any intelligent investor will sign up to.
So conventional gilts are lousy value – the 10-year probably has 10-15% capital downside on a 1% upturn in yields – and in fact, when you look at fund portfolios, you find that most managers who do hold conventional gilts hold only very short-dated ones where there’s no such downside risk.
Next out along the yield curve are corporate bonds, but we can jump over AAA and AA rated bonds because they yield no more than gilts. You need to get to the bottom of investment grade – BB – to get a yield pick-up and more and more funds have big holdings of high-yield or junk bonds with lower ratings. The problem here is that a rise in interest rates will mean higher financing costs when companies need to refinance their debt, and the kind of businesses that have C ratings will probably have to pay a much bigger yield premium when interest rates rise – which suggests default rates on high yield bonds will rise. Then you ask if the current yield premium you get in high yield is sufficient compensation for that risk, and the answer is Yes only if you believe the current gap between gilt and high yield bond yields will remain the same. But any crisis is likely to see the gap balloon out, at least temporarily. That suggests high yield bonds are a very risky place to be, on top of which John Snowden’s liquidity concerns are shared – off the record – by most managers I speak to.
Where else can you find a safe haven? Chris Burvill’s answer is index-linked gilts, in which he now holds 10% of his fund’s assets. Linkers are also a big holding of absolute return managers like Ruffer and Troy. Burvill admits that after last year’s astonishing gains in index-linked, they no longer offer sensible value in relation to the short-term inflation outlook. But if you are thinking about the end-game they may.
After financial repression, expect inflation
The argument here is that we have had five year of financial repression – minimal interest rates plus QE plus regulations forcing banks and insurers to hold more government bonds. Once you reach negative interest rate territory, you have reached the end of the road – repression can only result in people doing what the Swiss are already doing, hiring bank safe deposit boxes in which to store banknotes – in their case to avoid the negative interest now charged on Swiss Franc deposits. Clearly at this point financial repression starts to have deflationary effects.
So end-game theorists reckon the next move has to be towards inflation. The argument here is that QE has already called into question the independence of central banks, since no central bank would undertake large-scale QE without the backing of its Treasury. We are likely to see further blurring of the boundary between political control and central bank control of monetary policy. Another way of putting it is that the distinction between monetary and fiscal policy is breaking down.
Either way, what policymakers want is inflation, to erode stubbornly high levels of government and household debt. And the trouble is that by the time they get it, it is likely to be accelerating past current inflation targets. In which case, index-linked gilts are the safe haven everyone will want to flee to.
I don’t think I’m ready to embrace this argument completely, though I had already been thinking about a strategic investment in index-linked. I do feel sure I don’t want to own any conventional bonds – I don’t want those with long duration because of downside capital risk, and I don’t want those with no duration because they deliver no return.
I would urge any investor with significant capital in long-duration conventional bonds to review their holdings. A panicking crowd all rushing for the exit from bonds remains the most likely cause of the next major market crisis.
If that is a realistic scenario, it’s also realistic to expect that equities will drop and recover – because there will not necessarily be a change in valuations, assuming the economic trends remain unchanged. So having, as Chris Burvill does, about 15% of your assets in cash ready to pick up bargains may also prove a worthwhile tactic for 2015.
Chris Gilchrist, April 2015
Decumulate your pension with care
The new pension freedoms effective from 6th April will enable many more people to hold their pension funds in investments and draw income from them. But many people are likely to underestimate the risk.
If you draw more than the natural income – dividends, interest and rents – from your investments you risk capital erosion. Quite how severe this can be depends on the pattern of returns as much as their size. Research shows that if your investments fall significantly in value in years 1 or 2, at a time when you are withdrawing capital to supplement income, there is a high probability that your money will run out before you do, even if returns are good thereafter.
The market does not deliver straight-line returns
Contrariwise, if you get a storming bull market in years 1 and 2 of your investment, then even if you do withdraw capital at a steady rate the chances are that your money will outlive you.
Neither of these patterns are captured in normal linear compound interest projections, where exactly the same rate of return is assumed each year. That is not a significant problem for the accumulation of capital, because if you are investing a regular sum, then the outcome from a linear compound rate won’t differ much from a variable pattern of short-term returns that sum to the same rate. In fact, more volatility generally benefits pound-cost averaging during accumulation – you buy more units when prices fall – whereas on the contrary, big variations in year to year returns when you are drawing more than natural income can result in “pound cost ravaging”. If your portfolio value falls by 15% and you withdraw 5% of the original value, you will now need a 25% increase to get back to your initial value.
Investment advisers are struggling to come up with sensible decumulation investment strategies that work regardless of whether years 1 and 2 are good or terrible, which is of course unknown and will be unknown at the start of any period of decumulation.
Since “cautious” portfolios with no more than 50% in equities fell in value by as much as 30-40% in 2008, it is almost impossible to design a conventional “long-only” portfolio that would not risk repeating this performance in similar circumstances.
The problem is compounded because fixed interest, which can be a bolt-hole in normal circumstances, could now be defined as offering “return-free risk”. Investment managers may say they can see bond yields staying flat for yet another year or even longer as more waves of QE suppress yields, but I would not like to make my retirement dependent on picking the right moment to switch out of bonds into equities. And going into decumulation now with, say, a 40% exposure to bonds strikes me as taking on colossal risk for two reasons: one, bond yields are already low and interest rates are likely to rise, with possible sharp reductions in the capital value of bonds; and two, inflation is low but could easily return to levels of 2-3% and eat into both capital and income.
Holding cash is safest
In any case, if you want – as many people will – to draw an income of 4% or 5% from your fund, gilts are useless since none of them yield that much. To get 5% you need to buy lower-grade corporate bonds verging on high-yield or junk. But how many pensioners really want to bicycle along the edge of a cliff?
The old-fashioned answer to the problem of risk at the start of decumulation was to park a capital sum equal to the first two, three or four years’ income in a deposit account and invest the rest in a standard “balanced” portfolio with 60% in equities. This was fine when you got a return of inflation-plus-2% on your deposit – but now that your interest is less than the core rate of inflation? Still, this remains the least risky way to cope with the unknowable “sequence of returns” problem.
The financial engineers are busy creating packaged solutions and you can expect to see many featured in the financial pages over the rest of this year. Here is an initial list, which I will update with more detailed comments in coming months.
Four ways to reduce risk
Guarantees. A big insurance company can offer a guarantee either of the capital value of a portfolio or of the income it generates. It can even offer an upward-ratchet guarantee to underpin the income. But with an annual cost of about 2%, the guarantees are at present so expensive that few people will consider this worthwhile.
Absolute return. Cash-plus or absolute return style investing using “global macro” hedge fund techniques has done pretty well since 2008, with some funds having generated a steady annual return of 7%. A large chunk of your fund invested in this way would insulate your capital from doomsday, but you would be wise to spread it across several carefully selected managers. You could use a set of these funds to hold your first few years’ income.
Multi-asset. In theory, spreading capital across many non-correlated asset classes can reduce the risk of 2008-style capital loss. The trouble is that many of these asset classes are either illiquid (like physical property or private equity) or are in fact simply sub-classes of listed equity, all of which will tend – as they did in 2008 – to rush towards zero together in a crisis. Still, you can expect some convincing spiels from managers of new-style multi-asset funds along with the results of a variety of mathematical “stress tests” proving how resilient the fund will be.
Tactical. Tactical asset allocation is the current term for very active trading between asset classes, usually using low-cost Exchange Traded Funds. Managers use technical indicators, especially those relating to volatility and correlation, to assess relative risk and signal timely switches. History suggests that since consistently correct market timing is the hardest and most elusive skill in the investment world, the wheels will come off at some point.
If you are moving into the decumulation phase, you need to review your investment strategy. “Path-dependent” stochastic modelling is the latest adviser fad and will tell you the probability of reaching certain financial goals or of running out of money, but unfortunately you need a maths degree to understand the assumptions on which the stochastic modelling engine is built. So my preference is to use simple linear projections but then apply common sense to the investment solution.
Historical data tells you the maximum peak to trough loss incurred in the indices of the major asset classes – about 45% in equities, 20% in high-yield bonds and 10% in gilts. Many individual securities and funds fell by half as much again in the 2008 crisis. If you could not withstand falls of that magnitude on your current portfolio – together with a 3-year delay until recovery – then I suggest you may want to make some judicious adjustments.
Chris Gilchrist, March 2015