Matthew Yeates at Seven Investment Management outlines the most attractive alternative asset opportunities offering protection against the risk of further bond and equity volatility.
The stock market wobbles that characterised the beginning of this year attracted many a headline, but it was arguably a case of a return to business as usual, following month after month of disconcertingly low volatility the year before.
Complacency can take us all by surprise, but it could be argued that multi-asset investors have a greater tendency to err towards a ‘glass half-empty’ approach to investment thinking. Certainly, the scenario-driven, what-if approach can encourage a focus on downside risk, and portfolio insurance is something that we have put into play over the past several months.
February’s volatility meant that Seven Investment Management (7IM) was able to exercise one of its EuroStoxx 50 put options, which had been purchased to protect portfolios against the very sort of scenario we saw earlier in the year. Put options are, in essence, insurance policies that provide contractual diversification against falls in equity prices.
The low-volatility environment of 2017 made for an attractive entry point for those types of options, and while in the US the costs have moved back towards relative norms, we still see some opportunities for insuring equity market risk – in Europe, for example. So while we are by no means stock market ‘bears’ at the time of writing, it doesn’t feel like a time to abandon our insurance.
That said, while the current period of economic growth might be getting long in the tooth, and we certainly remain vigilant when analysing key economic and market indicators, global growth remains strong and there are many reasons to be cheerful. So maybe we are taking a more glass half-full, rather than half-empty, approach now – buoyed, perhaps, by those put options.
However, over the past six months or so, something that has arguably generated relatively little noise but has serious implications for multi-asset portfolios is the state of the bond market. US 10-year treasury yields moved almost 1 per cent from their low point in September last year to their peak of more than 3 per cent in April.
To put that move into perspective, if you bought a 10-year government bond around the start of September last year, you could have been locking in an income that equates to around 2 per cent a year. However, the move from that level to the highs of more than 3 per cent this year would have wiped more than four years’ worth of that income, or 8 per cent, off the capital value.
What is more surprising is that this bond sell-off has come during a period of equity market volatility – the very time investors would have traditionally assumed that bonds could do well. ‘Bonds down, equities down’ is probably the worst-case scenario for any multi-asset investor. The theory goes that as equity markets sell off, investor demand for the fixed payments available from bonds increases, pushing up prices. Traditional multi-asset portfolios are built on this logic. When this is brought into question, as was the case during the opening months of 2018, the real Achilles heel of multi-asset investing is revealed: a world where equities and bonds can go down in value at the same time. The dreaded taper tantrum.
This is a problem that 7IM has been talking about for some time and addressing in portfolios through an overweight to alternative assets. We use these assets to spread the sources of diversification by looking at assets outside of traditional bond and equity investments.
Aside from put options, we have used inflation swaps to help us navigate the market environment. These gain in value when expectations of future inflation increase, and lose value when inflation expectations decrease. They are similar to inflation-linked bonds, which also embed inflation protection, but they don’t have the exposure to interest rates that is embedded in inflation-linked bonds.
This difference is important, since it allows a view targeted more specifically on inflation. While raised US inflation expectations have driven bond yields higher, they are still lower than the historical average, held down by continued disappointments since the oil price crash in 2014.
Strong economic expansion in the US, alongside the fiscal stimuli being enacted by president Donald Trump, should push US inflation higher. We continue to hold custom-built certificates that give us exposure to upside surprises in US inflation. 2018 is a reminder that inflation-linked bonds may not actually provide protection against the risk many investors’ portfolios are targeted to limit, namely rising inflation expectations. In other words, multi-asset managers need to look outside the box.
That’s not to say we are completely turning our backs on bonds. We maintain an overweight position to emerging market bonds across all risk profiles. Yields continue to be attractive compared with their developed market counterparts. It’s also worth remembering that government bonds still offer protection against both a slowdown in growth and geopolitical risk, and while the move from quantitative easing to quantitative tightening might point to higher bond yields, they could fall back in the short term. Given where yields are right now, multi-asset managers face a difficult balancing act.
Reasons to be cheerful
However, there’s plenty to feel cheerful about. We remain underweight in UK large-cap equities, but we are closer to neutral than we have been in the past four years, on the grounds that international investors, cautious regarding the implications of Brexit, may have taken pessimism a step too far.
We remain underweight in the mid-cap space, despite low valuations, as the underlying earnings picture reflects the weak UK economy. We are looking for a turnaround in this area before adding further to our portfolio. We remain bullish in frontier markets, which remain unloved and under-owned globally, for our more adventurous portfolios. This is a position we started to build up a year ago, on valuation grounds but also because we think frontier markets are better able to avoid becoming the subject of Trump rhetoric, not to mention tit-for-tat trade wars. To date, frontier markets have weathered the rhetoric relatively unscathed; in a world where many markets have become correlated, they have been something of an exception over the past year or so.
Back in 1949 the economist and investor Benjamin Graham argued: ‘In the short run, the market is a voting machine, but in the long run, it is a weighing machine.’ Whether or not the return to volatility we saw earlier this year goes on to characterise 2018, this is worth bearing in mind. Ignoring the market noise and concentrating on fundamentals is absolutely key, alongside looking at what is going on behind the big headlines. Sometimes the really significant stories are concealed by overblown headlines.
THE INFORMATION contained in this document is marketing and does not constitute investment advice, and if you are in any doubt about the suitability of the investment or service, you should consult a professional financial adviser. The value of investments and the income from them can fall as well as rise, and you may not get back the full amount invested. Seven Investment Management LLP is authorised and regulated by the Financial Conduct Authority and the Jersey Financial Services Commission. Member of the London Stock Exchange. Registered office: 55 Bishopsgate, London EC2N 3AS. Registered in England and Wales No. OC378740.