Investment Comment October 2012

Prudent risk-taking was rewarded in the recent quarter with most equity markets rising at least 3% (unhedged) despite strength in sterling. Previous laggard stock markets in Europe ex-UK, Pacific ex-Japan and Emerging Markets gained the most in sterling terms, while the S&P 500 lagged. Japan, a continuous underperformer in recent years, fell for the second quarter in a row. Corporate bonds rose, with lower quality, higher yielding bonds faring best. Sovereign bonds retreated as yields ended the quarter modestly higher. In sum, the quarter evidenced a partial de-flating of what might be described as a “fear bubble” that had until now favoured risk-free assets.

The Age of Central Banks: More than anything else, developments in monetary policy set the tone for markets last quarter. A brief review is worthwhile. We believe the third quarter will go down as the point when the central banks went “all in”.

In America, Chairman Bernanke pre-committed to years of open-ended money-printing in the midst of an inflationary backdrop, justifying the move as necessary to reduce unemployment. While even modest short-term success could see risk assets rally further, the consequences of such unconventional policy will only become clear in hindsight. Venturing a guess, it is not hard to envision high rates of US inflation several years from now with deleterious effects on fixed interest assets.

In Europe, Bernanke’s contemporary at MIT, Mario Draghi, governor of the ECB, committed to do “whatever it takes” to preserve the Euro. While his open-ended plan to purchase the sovereign debt of Spain and Italy in exchange for budgetary austerity appeared more justified against a crisis backdrop, all is not well in the Euro zone. The divergence in productivity between the north and south coupled with unsustainable overall debt burdens in Greece, Portugal, Spain and Italy has turned the Euro into what economist Roger Bootle of Capital Economics describes as a “depression-making machine” (Fortune, 8 October, 2012, p51). Solutions that would create growth exist, namely certain countries leaving the block, devaluing their currencies and renegotiating their debts. Against this, the political commitment to the Euro project is profound and the desire to avoid short-term pain threatens to spread necessary deleveraging over many, many years.

Last but not least, the Bank of England and the Bank of Japan both increased the scale of their existing asset purchase programs. The former has the luxury of positive inflation and a disciplined fiscal backdrop suggesting some likelihood of success. The latter has an economy stuck deep in deflation and appears all too reluctant to embrace similar money-printing strategies that have failed in the past.

Asset Allocation: How should investors deploy capital against such an unstable backdrop? Time horizon matters. Strategically (5-10 years) we can say with some conviction that inflation-adjusted total returns available from equities will outperform those available from bonds. This is because earnings yields in most equity markets compare very favourably to bond yields relative to history. Further, should inflation pick up, corporate dividends can rise apace whereas fixed coupons cannot.

In the medium term (1-2 years) it is less clear, though still our base case remains that equities will outperform bonds. Consider how far we have come: The broad UK stock market has risen 94% off its March 2009 lows; indeed the S&P 500 has returned 127%. Western stock markets would appear to be in the latter innings of a four-year cyclical bull market, at a point where a turn in sentiment could cause material mark-to-market losses. The tailwinds that have pushed markets may not sustain: Valuations on current earnings appear attractive but corporate margins are well above trend, especially in America. Fiscal profligacy has boosted incomes in the US but the fiscal cliff looms next year; and in Europe pro-cyclical austerity is exacerbating the recession. Aggressive monetary policy is used to justify a fully-invested posture, though such policies may well be subject to the law of diminishing returns: high debt burdens and the need for current income curtail the demand for credit no matter how ample the supply. As an aside, with memories of recent losses still fresh in their minds retail investors cannot be counted on to support the market en masse. In short, on a 1-2 year view, on our current trajectory of money-printing and open-ended budget deficits to combat debt overhangs and low growth worldwide, it is hard to see a sustained return of animal spirits. We recommend market weighting equities, overweighting Asia and Europe at the expense of North America.

How do we approach valuation at the market level and which markets appear to offer the best expected return should valuations mean-revert?

North America: To quote Warren Buffett, the percentage of total market cap to GNP is “probably the best single measure of where valuations stand at any given moment.” Over a full market cycle we can extract an expected return combining dividend yield (1.5-2%), long-term earnings growth (5-6%) and a mean-reversion of the ratio of total market value / GDP (-20%). On this basis, the US stock market at 100% of GDP (compared to a 40-year average of 80%) is priced for low single-digit total returns. This expectation is corroborated by other measures such as the Shiller P/E which cyclically adjusts the earnings denominator. On this evidence and given the late-stage of the current cyclical bull market, we recommend underweighting US equities.

Europe: Europe, and the UK, appear much more attractive on the basis of current valuation relative to the history. Markets tend to discount the present, and carefully selected European equities at current valuations could well provide high-single-digit to low-double-digit total returns comprised of generous dividend yields and capital growth. The caveat is that a break-up of the Euro zone would be bound to cause market and company-specific stress and so the question is whether one could sleep at night knowing there is this possibility of outsized volatility. We recommend overweighting European and UK equities.

Asia: Despite slowing growth in China, and a recent escalation in nationalistic tensions, the region offers the most compelling growth outlook globally. In the case of China, with local shares trading at historically low valuations. We recommend overweighting China and Japan.

Fixed Income: While fixed income has a place in most portfolios, the case for the asset class now does not appear compelling in our base case. This is because developed market sovereign yields have been manipulated downward by central banks and lack a margin of safety. In a similar vein, emerging market sovereign yields have also tightened materially, albeit with more justification. Corporate credit offers better reward for risk taken but absolute yields-to-maturity are also low and generally uncompetitive with high dividend yield, low beta equities. High yield bonds are a specialist area but generally we would opine that high yield bonds currently trading at or above par offer “return-free risk”. Distressed debt is an area of opportunity, the challenge being that central banks are delaying the deleveraging that will create future returns.

Cash: Though counterintuitive, we believe holding an allocation of cash is worthwhile at this stage. Some context is in order: In 1981 when interest rates on cash were well into double digits, holding cash was a mistake: equities and bonds were cheap and a better investment at that time. Conversely, today cash affords optionality despite its lack of yield: Fixed interest offers only a small yield pick-up and comes with capital risk, and if the pricing of financial assets improves, cash can be deployed at higher rates of return.

Risk warnings
This document has been prepared based on our understanding of current UK law and HM Revenue and Customs practice, both of which may be the subject of change in the future. The opinions expressed herein are those of Cantab Asset Management Ltd and should not be construed as investment advice. Cantab Asset Management Ltd is authorised and regulated by the Financial Conduct Authority. As with all equity-based and bond-based investments, the value and the income therefrom can fall as well as rise and you may not get back all the money that you invested. The value of overseas securities will be influenced by the exchange rate used to convert these to sterling. Investments in stocks and shares should therefore be viewed as a medium to long-term investment. Past performance is not a guide to the future. It is important to note that in selecting ESG investments, a screening out process has taken place which eliminates many investments potentially providing good financial returns. By reducing the universe of possible investments, the investment performance of ESG portfolios might be less than that potentially produced by selecting from the larger unscreened universe.