How on earth can anyone be expected to keep up with all this and react in a timely fashion?
The answer is of course that we cannot, and should we be tempted to try, we would be drawn into the casino of financial markets which we feel sure would end badly for all concerned.
The questions we continually ask of ourselves when faced with new developments are simple:
- “Does this new information really change the basic problem of excessive debt in the developed world combined with anaemic growth?”
- “Is this a game changer or just another short-term fix unlikely to last more than a few days or weeks?”
Sadly it seems almost always the latter. So the markets carry on rising and falling, sometimes quite dramatically, but staying within a trading range. The FTSE 100 index for example, has broadly traded between 5,000 and 6,000 since January 2010. Should we move outside this range, with little change in the fundamentals, opportunities may well arise.
Against this background we feel the best course of action is broadly to do nothing. Our portfolios have been set up for the conditions we currently face and until we detect real long-term improvement in the economy or more compelling valuations it is hard to envisage a dramatic change.
Inactivity, however, can prove more difficult than might be imagined. We are, after all, active managers employed to add value by switching between and within the various asset classes. Surely we should be doing something to justify our fee?
James Montier reminds us in his excellent book entitled “Value Investing” of a study carried out by academics Bar-Eli et al (2007) of football goalkeepers from top leagues worldwide. In broad terms the study shows that penalty takers evenly distribute their kicks one third each to the left, right and middle of the goalmouth.
Despite this the goalkeepers dived left or right 94% of the time. Further analysis showed that the chances of saving the kick were highest (60%) when the keeper stood his ground in the middle of the goal, why therefore do keepers feel the need to dive left or right? The ‘keeper feels he must be seen to make an effort, simply standing his ground might produce the best chance of a positive outcome but the pressure in front of a crowd to do something is over-whelming.
We are keeping busy analysing developments, meeting clients and fund managers, calculating ratios and volatility but our conclusions broadly support our current positioning; little changes.
We questioned earlier this year whether the strength in equity markets could be maintained in the face of declining economic growth in the US and the continued political and debt problems in the Eurozone.
In the event, markets gave back some of the rise enjoyed in the first quarter but, by recent standards, the falls were quite modest. The MSCI World Index declined 4.4% in dollar terms partly due to the recovery in the dollar that benefited from the general feeling of unease. In almost every other currency the falls were much less.
Perhaps not surprisingly the dash for trash we witnessed in the first quarter was reversed at both country and stock levels.
Core government bond markets enjoyed a roller coaster ride with yields on ten-year bonds falling to record lows, only to rise again by the end of the quarter. In the UK we saw yields drop to below 1.5% something we would have thought impossible just a few years ago. Fears of declining economic activity caused significant falls in commodity prices (Brent Crude Oil down 25%) that may well lower inflation expectations allowing central bankers to embark on a further round of unconventional monetary easing, and so it goes on.
Our expectation is to continue grinding out reasonable returns, protecting capital from the insidious effects of negative real interest rates and over the longer run inflation and currency debasement. When looking at any investment we ask another simple question: “If I buy this asset, at the current price, how confident am I that the real value of my capital will be the same or higher in five years’ time?”
This helps cut through so much of the short-term noise in financial markets. Our central themes remain the same.
Cash is very likely to continue to be a poor store of value over the medium term. Debt levels in the developed world have rarely been higher than they are today and to solve the problem a transfer of wealth from those who have it to those who borrowed it needs to take place. If this does not happen by the simple methods of default and taxation, inflation and debasement are more likely to occur. Across the developed world in the 35 years after WW2 the average real interest rate was -1.94% per annum, gradually passing capital from the creditor to the debtor.
(The graph above shows how £100 placed on deposit in 1947 would be worth £954.10 after 35 years, assuming no income tax was paid. The reality however, is that after inflation is taken in to account the real value is only £85.45)
In bond markets we favour index-linked over conventional and, where mandates allow us, we are happy to gain exposure to some of the smaller currencies that we expect to be a sound store of value over the medium term.
In the equity markets we feel that top-quality companies with long track records of dividend and/or free cash flow growth look very attractive in both actual and relative terms. Such stocks seem to be regarded by the wider market as dull and boring but that may well be the best place to be until economic growth returns.
We were particularly pleased with the performance of our equity positions when the markets fell in May. Indeed, if we have more confidence in our equity holdings it is down to the skill of the underlying managers and the strong dividend flows that we expect to rise in line with or quicker than inflation.
In the absence of complete economic meltdown we are confident that any short-term quotation losses will be just that, over the medium term quality and value will win throughout.
Despite quite high levels of volatility we continue to favour the Far East and emerging markets over those of the developed world and are happy to hold some gold, directly or via funds, just in case.
