As the Chinese economy sees its seventh consecutive quarter of slowing annual growth, economic statistics weaken across the globe and government debt piles remain stubbornly large, it does not feel the right time to be reintroducing risk into investment portfolios. But, as behavioural finance practitioners are fond of saying, following instinct is not always the best investment strategy. Could now, when all appears to be gloomy, be the right time to abandon safety and move back into riskier assets?
Embracing safety has certainly been the most rewarding investment strategy over the past few years. Global bonds and gilts have been the best performing Investment Management Association sectors over the past five years while in equity, it has been the predictable, income-generative companies with strong visibility of earnings that have outperformed. Nestlé, for example, has outperformed the wider DJ Euro Stoxx index by around 60 per cent over five years.
So in an uncertain economic climate, investors have been choosing companies that offer some measure of certainty. The problem is that although the economic environment remains uncertain, these ‘quality’ investments now look extremely expensive on more conventional measures of value. The yield on 10-year gilts has widened out over the past few months, but remains at historically low levels. Nestlé trades on 20x earnings, compared to unloved, economically sensitive companies such as Xstrata on 10x, or M&S on 12x. These are crude comparisons, but it shows how much investors have been willing to pay for quality.
A number of multi-managers have decided that this is no longer a price worth paying. The background is showing small signs of improvement. At the margins, Purchasing Managers Index data and other leading indicators have been ticking up. The latest set of GDP figures from China, although weak, show investment, retail sales and industrial production all accelerating at the end of the quarter. Premier Wen Jiabao has said that he believes the difficult run for the economy is probably at an end. The US has its fiscal cliff and election looming, but its housing market is recovering and growth may be turning a corner. The eurozone crisis is far from resolved, but the situation looks marginally better than it did in the summer.
This is encouraging, but for most multi-managers the decision to embrace risk assets has nothing to do with any significant change in the economic environment. Cazenove Capital Management multi-manager co-manager Robin McDonald says: “Everyone agrees that the outlook for the economy and financial markets is incredibly uncertain. It is possible to make an equally compelling bull and bear case. However, the market has bid up the price of perceived certainty in an uncertain world – areas such as global bonds, tobacco, and pharmaceuticals – on the basis that, whatever happens, people will still buy food, nappies and cigarettes. But valuations are now very stretched.”
In other words, the valuation differential between safe and risky assets has become too great to ignore. The desire for safety has been so extreme that there does not have to be a profound shift in economic climate to make portfolios stuffed with bonds and safe-as-houses equities look over-cautious. These portfolios are positioned for an extremely negative scenario.
Thames River Capital joint head of multi-manager Gary Potter says: “The market has been so focused on risk reduction that the notion that people should take risk has become completely foreign. The mantra has become ‘what is risk’ and investors are forgetting to look at the return profile. Over 10 years, the FTSE All-Share has returned 138.8 per cent, compared to just 46.7 per cent from the sterling corporate bond sector. De-risking portfolios because investors are scared is absolutely not the answer. The amount of money going into low-risk assets is not justified by the return profile.”
Momentum Global Investment Management chief investment officer Mike Allen says that the value in gilts is “non-existent”. He says: “We have no gilts and no treasuries in our portfolio, simply on valuation grounds. We are looking at asset classes in terms of the risk of a permanent depletion of capital and there is simply not enough margin of safety.”
While it is easy to agree that ‘quality’ assets look expensive, it is less easy to decide where to redeploy that capital. The environment is not yet right for a wholesale move back into economically-sensitive assets. Allen says he has recently exited his position in high-yield bonds. The holding had worked well for him, but after a period of strong performance they now look fully valued. He has yet to reinvest much of that money, holding it in cash until the environment becomes a little clearer.
That said, he has started to shift his equity weighting towards more cyclical managers. He has moved away from quality focused managers to more ‘value’-oriented managers recently. McDonald has also moved away from quality-focused managers such as Neil Woodford at Invesco Perpetual, to cyclical managers such as Sanjeev Shah at Fidelity.
Potter says he is not in favour of piling into deep cyclicals at this stage, pointing out that some cyclical companies still look vulnerable. Morgan Crucible, for example, recently had a profits warning. Instead he is keeping faith with style-agnostic managers such as Richard Buxton, who manages the Schroder UK Alpha Plus fund and Mark Costar who manages JO Hambro Capital Management UK Growth.
Managers are slowly moving back into higher beta markets such as Europe and emerging markets, and away from quality markets such as the US, but this is happening only at the margin.
McDonald says: “The US equity market used to be a safe haven. The economy has been seen as further through the crisis than the UK and Europe, with the banking sector largely recapitalised. But the US market is trading at all-time highs, whereas Japan and Europe are back to where they were in March 2009. If people could go back and buy the US at March 2009 levels, they would jump at the chance, but they are unwilling to do the same with Japan or Europe.”
McDonald says that the price investors pay for certain assets is crucial, as is an examination of fund flows. He points out that if there is a lurch down in the economic situation, investors are unlikely to sell down Japan or Europe, because they have already sold. Selling pressure may start to hit markets such as the US. “Defensives are less defensive,” he says. “The US is not a safe haven because everyone owns it. It depends how investors think about risk.”
There are relatively few signs of a wholesale move back into Europe, and where investors have moved back it has tended to be with some caution. For example, Premier investment director David Hambidge, attracted by the yield and the low valuations, has moved back into European markets, but has taken exposure through equity income funds and structured products to mitigate the risk.
When is the market likely to begin to appreciate these unloved areas? To some extent, the process has already started. UK Smaller Companies and Europe are the top-performing sectors this year to date, with the Europe ex UK sector up 15.4 per cent. Gilts and global bonds have been among the weakest sectors. Within the UK All Companies sector, it has been funds such as Schroder Recovery, with its deep value style and exposure to unloved cyclical areas such as banks, that have topped the tables. Growth funds, such as JOHCM UK Growth and Jupiter UK Growth have also been strong performers. In the equity income sector, quality-focused managers such as Woodford have had a more difficult year, while more flexible, smaller cap or ‘value’ managers have performed well.
McDonald says: “In the first quarter of next year, with the fiscal cliff and the election out of the way, if the European leading indicators continue to tick higher, there could well be a mad scramble into perceived ‘risky’ assets that are trading cheaply. If any degree of certainty comes into the economic outlook, cyclical business may start to look better.”
This is an important point. The situation has not yet been bad enough for many investors to feel the pain. Because of their outperformance, the major indices have become skewed to defensive assets in recent years. Therefore, while an overweight exposure to defensive assets may hurt relative performance, it will only have left investors a couple of per cent below the index. However, if the outperformance of cyclical assets continues, and in particular if there is a scramble to cyclical assets in 2013, the contrast between the performance of those funds continuing to hold defensive stocks and those that have embraced more risk may become more profound. Those holding very defensive portfolios may be forced to take more risk to address this.
Of course, the old line that markets can stay irrational longer than investors can stay solvent also applies. Experts have been predicting a sharp setback in gilts for a number of years, but until relatively recently, yields have continued to fall. Valuation is leading investors in one direction, while the market is leading them in another. Something has to give.