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Mark Dampier: Will cash beat bonds as a defensive call?

June is typically a tough month for stock markets. 2017 has been no exception and the UK in particular has experienced a harder time over the past few weeks. To be fair, it has had a lot to contend with given the general election result.

A left-wing socialist party is standing in the wings, ready to take-over from what can only be described as a lacklustre Tory government which, ironically, appears to moving more to the left themselves. For the first time in a long while political risk is back on the agenda, so it is not surprising the market does not know how to price it in.

Clamour for ‘the end of austerity’ continues, when it was never really there in the first place. I recently read we are still borrowing £5 million every hour of every day. This hardly suggests the government has tightened its purse strings.

The stark reality is that taxes will need to go up; although I think we are near the limit of what can be raised from ‘normal’ taxes, such as income tax. As Merryn Somerset-Webb (who in my opinion is one of the best commentators around) recently remarked, taxes go where the money is. A large proportion of the nation’s money is in wealth assets, so a new wealth-tax, probably dressed as something else, would not be a surprise to me.

Arriving at a sensible asset allocation

As I have written many times before, this is an incredibly difficult time to advise on investments and asset allocation. The temptation is to sit on the side-lines in cash, waiting for the stock market to fall, and the opportunity to pile back in at the bottom. Many people have done just that, only to witness five years of stock market gains pass them by. It is not just private clients that have fallen into this trap; many fund managers have also fallen foul.

Sebastian Lyon, who launched Troy’s Trojan Fund in May 2001, seeks to buy high-quality investments at a sensible price. This approach served him well in the fund’s early years, and good performance was driven by strategic asset allocation and strong stock selection.

However, this strategy has proven far more difficult to carry out in recent years as the price of high-quality stocks has risen sharply. Most stock markets are now highly overvalued, in his view, and he has positioned the fund defensively as a result.

When equities are expensive, bond markets have historically provided a haven. The performance of these asset classes tends to be negatively correlated, and a balance of equities and bonds has served investors well for more than 30 years. However, as both equities and bonds are currently viewed as expensive, this relationship looks to have broken down.

Mr Lyon has therefore favoured holding cash, rather than bonds, in order to position the fund defensively. 30 per cent of the fund is currently held in cash and the bonds he does own are typically short duration US and UK inflation-linked bonds, which he feels offer better protection than conventional bonds.

Equities account for around 40 per cent of the portfolio, where the manager has focused on large consumer-goods companies, such as British American Tobacco. A further 8 per cent of the fund is invested in gold.

So, all in all a pretty pessimistic prognosis from Mr Lyon. He has been singing from this same hymn sheet for the past five years, so has missed much of the stock market’s strong performance. Yet, the reasoning behind the dire picture he paints is entirely reasonable. The last interest rate rise in the UK was in July 2007, and the ultra-low rates we have experienced since then is surely storing up trouble for the future.

At some stage, I am sure Mr Lyon will be proven correct, but his investors need to be patient. While there is no question he has been too early to the party, I am convinced he will have the confidence and conviction to buy back into the market at a time when most investors lose their heads. It will be at that moment he proves his worth. I am willing to bet most private investors will not have that courage.


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