By Guy Myles, Chief Investment Officer and Chief Executive, Flying Colours Finance Ltd
24 October 2020
For most of our clients we manage the money in their pension, ISAs and investment accounts. For these people there isn’t a reserve or a plan B. If we make mistakes this will change people’s lives so, for us, this is not an academic exercise or an ‘opportunity’ to show how clever we are.
It is a seriously responsibility and one where we are cautious about making mistakes.
The question for us and our clients is how then can we capture the long-term upside in investment markets, take steps that create a higher return or reduce risk and do this without risking the success of the whole portfolio? Compared to the industry our approach is different and, in our opinion, better suited to managing risk.
We start from an analysis of risk for our investors
We start from an analysis of risk for our investors. We think hard about what might go wrong and try to make sure serious mistakes do not happen in our portfolios. It sounds simple but most fund managers chase returns and try to beat benchmarks without thinking too carefully of what could go wrong.
Performance chasing has been a big factor in the well-publicised disasters for the industry. We think we can often predict what happens next but we never allow any idea to become too big in the portfolios because we know we could be wrong. We may sacrifice stellar returns in some years, but we can sleep at night.
We try to maximise the benefits of diversification
We try to maximise the benefits of diversification. This forms part of the approach of most managers but, in our opinion, they don’t do it very well. Diversification is the use of many different types of investment in combination to try and dilute the effect the success or failure of one might have on the portfolio. Done well it smooths out the journey without reducing the likely returns over time.
The problem is that some assets appear to be great diversifiers when everything is going well but they can turn sour when you need them most. A good example in recent times is the widespread avoidance of government bonds which have been discarded in favour of alternatives like property or absolute return funds. These alternatives were meant to offer better returns with similar risk control benefits to government bonds.
Predictably, for us, once the stockmarket became distressed all these types of investments went backwards at the same time. The diversification had failed and investors unwittingly ended up holding all risky assets. The lesson should be to look at the potential causes of loss and try and build your portfolio to avoid them. Avoiding mistakes is more important for long term success than brilliant new ideas.
The most important principle we use to control risk
The most important principle we use to control risk is to assess the likely future problems and try and ensure, no matter what happens, our clients are successful. This means we can’t just apply one rule book to risk management and never change it.
The risk for investors in 2019 was a traditional economic cycle and recession which, despite Covid obscuring things, is in many ways what happened. Weak demand and falling profitability led to a fall in interest rates. Our portfolios were able to cushion this problem through high holdings in government bonds. Despite that success we cannot just repeat the same formula because the risks to us seem to have changed.
See below a summary analysis of what we forecast is happening today and what happens next.
The future of investment markets from October 2020
After a long term build up in global debt and economic imbalances the global economy entered 2020 in a fragile state. Covid has collapsed demand in most global economies and required governments to step up spending hugely and resort to money printing to finance this. The crisis has accelerated trends that were already present and makes a decisive reckoning likely but which direction will the world take?
There are three possible scenarios for global economies and investment markets.
- A deflationary depression – a collapse in demand and high unemployment combined with very low or negative inflation rates and interest rates
- Inflationary growth – full employment and higher wages alongside economic growth but with higher rates of inflation
- Stagflation – high rates of inflation alongside weak or negative rates of growth
As you’d imagine these scenarios are very different and will have a profound effect on investment markets and portfolios. If you’ve read our other commentaries you will know we believe the most likely outcome is inflationary growth but, even feeling confident our analysis is correct, I wouldn’t put the probability of this higher than 70%. The reason is that the direction the world takes will be decided by decisions taken by Governments, in particular the US government, and these decisions haven’t been taken yet. Any analysis can therefore be wrong so, as fund managers, we must make sure our clients are OK in all scenarios.
To help you understand how we weigh risks and build portfolios lets look at each of these scenarios in turn.
A deflationary depression
For this to happen the world needs to continue with the policies they have had in place over the last 20 years.
- Open globalised trading allowing low cost Chinese imports to continue to depress domestic wages but provide cheaper goods for consumers
- The largest role in directing the economy taken up by central banks using low interest rates and quantitative easing to try and stimulate demand. We think of this as ‘pushing on a string’ because low interest rates have stopped working.
- A focus on the sustainability of debt making austerity and debt repayment take precedence over full employment
The above will happen if the existing approach to economic management continues. It is more of the same. Given the huge debt build up we have seen globally we should expect the impact of the policies above to be similar with low or negative inflation, very low economic and wage growth. In our opinion this is a recipe for societal unrest but many commentators are calling for exactly this recipe. If governments opt for higher taxes and or lower spending after Covid you will know they have chosen this route.
The impacts on portfolios are simple to understand. Lower inflation or deflation will mean we see some positive returns from bonds as yields fall even further. For example if the yields in the US bond market fall to the level we see in the Euro you could expect a return in your US bonds of 5% or more. This isn’t exciting of course but in this world any positive returns will be valuable. The stockmarket fundamentals will be weak and profit growth will come under pressure. We will see leadership continue in the technology sector but returns will be low, and given current market valuations, may be negative over many years.
For investors chasing returns in property, high yield or junk bonds and smaller companies this world would be very damaging to returns. To mitigate this scenario you must retain a reasonable weighting in government bonds, despite the low returns on offer, and maintain broadly diversified and predominantly main market equity holdings.
The risk of a deflationary depression means it is dangerous to turn up risk in portfolios.
As described in a longer briefing note this is the scenario we believe is most likely for the developed world to exit this crisis. Very high levels of debt, the risk of societal unrest and the need to maintain vibrant employment and prospects for young people make it unlikely any economy will maintain policies that crush growth for long. The trigger will be greatly expanded government deficits coming from either higher spending or tax cuts.
In 2020 up to half the bonds issued to finance Government borrowing have not been sold to investors but directly purchased by central banks. This is commonly called money printing and can be highly inflationary. In the short term there is little risk of inflation but this could change rapidly. The intellectual cover for this approach is something called Modern Monetary Theory which correctly states that governments that control their own currency (i.e. major economies not inside the Euro area) can issue as much new currency as they like with the only constraint being inflation. At the moment most authorities want to increase inflation but haven’t been able to. The scene is set for governments to seize this new power, run very large budget deficits waiting for inflation to start before reining it in. The risk, of course, is that inflation will reappear aggressively at some point.
A further reason we think inflation is the most likely route out of the crisis is that it has the potential to reduce the value of outstanding debt and remove a brake on long term growth. If interest rates are kept low we could see a beautiful deleveraging at the same time as inflation appears.
Full employment, reducing debt burden, what’s not to like I hear you ask. Well inflation is really a broad based way of reallocating wealth from one group to another rather like taxation. Increased inflation will be very bad for holders of bonds and cash as they see the value of their investments fall in spending power. Over time the effect of this could be dramatic. Another way to look at this would be a transfer from older people (low risk investors) to the young. Whether you think that is a good idea depends on your perspective but, in our opinion, politicians are likely to see it as a good idea.
The drivers of inflationary growth are likely to be
- A push back on globalisation and integration with China. Higher cost goods will be offset by better employment prospects within developed countries for a wider range of people. This is likely to lead to wage inflation.
- Government spending, or fiscal, taking over from central banks and monetary control. Excess government spending will be directed to try and rekindle inflation. This is a very difficult target to hit and governments will probably be poor at judging when to step back from this and there is the risk of much higher inflation than is expected.
- A focus on full employment and the acceptance that debt holders do not get fully repaid after inflation is accounted for.
This world would be very bad for cash and bond returns, neutral to positive for the stockmarket provided interest rates did not rise too fast. Within the stockmarket you would expect traditional industries (value stocks) and smaller companies (domestic focus vs international) to perform well. In the bond market inflation linked bonds offer excellent protection. Lastly gold is an attractive asset class at a time when inflation is high and bond yields low.
This is a variation on the inflationary scenario above but where the economy is weak. This famously happened in the 1970s and was prompted by the external shock of a massive rise in oil prices at a time when that was a major part of the economy and was compounded by heavily unionised workforces who collectively bargained for wage increases. Investors worry about this scenario because it is both bad for bonds and bad for the stockmarket and could therefore be very dangerous for investors’ portfolios.
In our opinion this scenario is unlikely but it is possible if conflict between the US and China ramps up and we see a sudden drop in trade flows. In some ways this kind of external shock would be comparable to the oil crisis of 40 years ago. Forecasting wars is very uncertain and obviously we all hope it doesn’t happen. We must plan for scenarios like this however and check how our portfolios would hold up
- A large external shock, such as war between China and the USA, leading to severe reductions in global trade and the need for massive domestic stimulus. The reduced productive capacity would mean this stimulus would hit an economy with less capacity to absorb it. This could lead to a reduction in economic activity at the same time as a rise in inflation.
For portfolios there would be a certain rush to safe haven assets. In normal times this would mean the US dollar but that couldn’t be relied upon. We should expect gold again to perform well and inflation linked bonds to perform better than traditional bonds. The stockmarket is likely to be weak until a resolution is found and all sectors, outside essential supplies and the defence industry, would likely fall in value.
This scenario is certainly possible but not something we think is probable. We still must prepare for it.
For investors today you should have a portfolio that means you will be OK no matter what direction the world takes. In our opinion, if you look at the world in the light of risks to your investments it is obvious you should be well diversified, maintain government bonds but alongside inflation linked bonds, favour larger companies and crucially hold some gold for ultimate diversification.
When we analyse external portfolio managers we very rarely find this approach but rather portfolios that will only do well in certain scenarios. This is risky.