Priceless – Tidings of Comfort & Joy

Ros Price, Investment Committee Member.

It’s the time of year when – at least until MiFID ll rule changes allow starting next January – when fund managers have inboxes deluged with the outlook for next year. Most make quite turgid reading I am sorry to say and that’s not just the content, but the writing style. Sometimes as you trawl through the tenth report you just wish they would all admit that the industry has no reliable crystal ball and would just suggest several scenarios that might conceivably come about, attaching a probability of happening to each scenario, and if they do come about, then what the market reaction could be and what they as a manger might plan to do to capture upside to investments or limit downside. It might be so much more constructive to look at potential outcomes!

Then of course the manager has to translate all these views into what he/she/the firm thinks might/will happen and finally to develop a conviction – a term I have never really understood as I was taught at school that a conviction was what you got for being found guilty of a criminal action….

This year, for us here in the UK it is all the more fraught by the political background of organising a sensible outcome of Brexit. Not to mention the other little local economic difficulties confronting us. I am something of a long-term and deeply engrained cynic. No matter what, politicians seem to make things more complex than needed – common sense appears not to be  in great supply in most political headquarters oddly enough. Perhaps because party has to come before country nowadays but that has to be veiled so as not to upset the electorate? Still at least we will have all the bling of a Royal Wedding here next Spring to stop us worrying about the long term productivity issues in the UK economy! Always good for a consumer spurt?

So back to the future so to speak and we need to bear in mind that despite the great financial crash ten years ago we are already nearing the longest bull market for balanced equity/bond portfolios in more than a hundred years. The difficulty this leaves the fund manager with of course, is that on many metrics markets look very fully if not overvalued.

The global economy however is now in pretty good shape – perhaps excepting the UK where growth is a little lacking. The tsunami of liquidity that has flowed from the major developed world central banks seems to have finally hit the spot  and even the much maligned EU economies are growing at what is a surprising rate currently. Japan, that graveyard of forecasting reputations for so many years since the market collapse at the end of the 1980s when the property bubble was finally pricked, has found a high level of corporate earnings growth that maybe has yet to be fully reflected in valuations.  Most forecasters seem to believe that the economy will continue to move upwards next year and as a result equity markets will echo that performance.  There is also consensus that inflation will pick up  – but only ‘a little’, although only a little is enough to hurt many consumers who have yet to benefit from all this growth via what they would see as a decent pay rise in both the UK and US. In the US we face a change in leadership at the Fed and the beginning of the withdrawal of all the liquidity of quantitative easing not to mention what might be looked on as an unusual political background. Despite all this equity markets carry on upwards and the Goldilocks scenario we were so used to when Alan Greenspan chaired the Federal Reserve seems to be firmly in place once more.

Of course we have to remind ourselves at this point that most forecasts will not really work out in the detail we are given them. So an alternative way of looking into the future is to ignore the very detailed numbers put out and look at the current trends in key drivers of the economy and how these may be affected over the coming year and as the year progresses to run checks against these factors and how they are developing to look ahead to potential market behaviour and of course to investment returns. One little complication in all this  – markets are supposed to look forward to outcomes in the global economy. So it is just possible that all the good growth we are looking forward to next year is fully priced into securities markets making the anxiety over current valuation levels a more pressing matter for resolution. Even more concerning perhaps are views that 2019 will see the beginning of a global slowing and so this is what markets with their forward looking hat on will begin to price in later in 2018. All of which re-enforces the view that we must carefully watch these drivers of growth and hence markets instead of hanging our investment hats on a  single forecast of aggregate growth in the year ahead.

Let’s look at these key economic drivers therefore which will be so key for markets and investors and stripping things down to a very simple view, there are six key drivers of returns, three of which are fairly straightforward true macro risk factors and then three more which could best be described as financial market macro factors. There are other influences but these six factors can be used to explain away between 75% and 90% of the variability of returns in  what we can consider to be the broader asset classes available to us for investment. Some of the factors will affect all basic asset classes whilst others are actually unique to a limited number of asset classes. Inherent in the idea  though is that using the six factors is its simplicity  and its starting point is the risk free rate – the return that will be generated by the safest asset class investors can use. To me, most importantly it is a simple , intuitive approach – so often we are asked to immerse ourselves in almost unnecessary mathematical solutions that in many cases actually take us away from a real investment process. Too often nowadays we get excited by what is in effect a short term iterative trading process that just to my mind is not investing. Yes you can make returns by trading but it is not investing.

The first macro driver  to consider is the level of real interest rates – this is what  you get paid in real terms to lend someone your money over a longer period.  It is important to observe how such rates are moving or as the case of recent years are being held down by central banks. In other words what is monetary policy doing? Next year sees some real potential policy changes by the central banks so this factor is high on the list of influences on the economy and markets especially bond markets. We know the Fed under Yellen has started a big turn round in policy in the US but we have a new hand on the tiller from February and which may make a change to policy speed. Here in Europe we know there are pressures on the ECB to make policy changes but we cannot be sure when/if those moves will come sooner or later. And in the UK after a single rate rise we cannot be sure how the vagaries of Brexit will affect policy. Japan has been a monetary law unto itself for several decades! Incidentally, interest rate levels can be a key factor in determining currency levels too.

The second important macro factor we can look at is the inflation rate. This is really a measure of changes in the so-called nominal prices of goods and services  and here the currency level can have a significant impact in the costs of goods especially imported goods. Equities appear not to be so badly affected by rising inflation bonds that have a fixed coupon and holders of such bonds like to receive a higher yield to compensate for any inflation shock to their investment in the case of rising inflation eating  away at real bond value. This stealthy erosion of value can be overlooked when inflation levels are relatively low as they are today.

The most obvious driver perhaps that I have left to last of these macro factors growth itself. It seems so obvious that readers wonder why we look at it. But growth can take sudden sharp and unexpected turns  – or as occasionally happens events that are so obvious get overlooked because they are simple events. (The real classic in the US is quite often the occurrence of severe winter weather. Sophisticated analysis forgets that three feet of snow for a week or more can make economic activity a little tricky!!). All sorts of influences can make unexpected change for good or bad. The real skill is to be able to look at what is happening to see what might happen and from that extrapolate what the market might make of these things and so give rise to a return view.

Markets are of course indicators of investors levels of fear and greed and the other three factors are more elements that express levels of these two sentiments. These are the financial market macro factors the first of which is a view on credit which looks at the differences in yields between corporate bonds and government bonds and then considers the risk of default on those bonds. Whilst in the main this looks at the chance of companies not repaying these bonds the default risk can extend to countries too, sovereign default – remember recent worries about Venezuela?

Then we look at equity itself and the risks attached to it– this can cover anything from earnings growth to default risk again, incorrect valuations  (up or down) and really takes in the so-called animal spirits which tend to feature in equity markets more than other asset classes. Obviously when considering equities there is the need to drill down to look at just how businesses are doing – are the management doing a good job, product market strategy per company, earnings, dividends etc. and this needs to be extrapolated across the whole market and probably for a reasonable amount of time too.

The final key factor in the more esoteric section relates to emerging markets and here political risk enters the calculation – investors are adding risk to their portfolios by investing in developing markets which tend to be less stable than rather more developed markets but can give rise to higher returns to compensate for that risk although there is also the higher risk of loss too.

Looking at the factors gives us the chance to evaluate the risks in the portfolios too and that helps to relate to the portfolio owners risk tolerance as well as the  potential for return. As we try to assess the potential for returns over the coming period, asset managers must compare and contrast these major factor outlooks in each asset class, taking care to estimate what the potential risk to the outcome is, so in effect building a probabilistic forecast of returns. Occasionally, managers get very close indeed to the actual outcome, but to get the flavour of the investment environment as it develops gives a manager a strong competitive edge. Investment is not –yet- a purely quantitative set of calculations and behavioural issues have very strong influences on performance too.

So there we have it  – we need to follow these key variables and try to work out what they say about the near future to tell us where markets are going and what returns might look like.

Merry Christmas!

And a Prosperous New Year!