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Peter Elston’s Investment Letter – Issue 19: November 2016

28 November 2016

The most interesting question in the world?

Here’s an interesting question: do the low or negative long-term real interest rates that prevail around the world signify a bleak economic outlook or are they what is required to stimulate spending and investment, and thus a bright economic outlook?

Both theories are supported by their own coherent reasoning. And yet one of them must be wrong. You cannot have both a bright and a bleak outlook.

Which is correct?

The argument in favour of the suggestion that (low) long-term real bond yields reflect (poor) long-term economic growth prospects is simple. As an economic agent, one has a choice; one can either invest in financial assets, the benchmark of which is a riskless bond, or in the economy via real assets that will provide a return commensurate with broad long-term GDP growth. Theory says that both should track each other. If economic growth falls, bonds become relatively more attractive. As investors buy them, their prices rise and their yields fall, thus redressing the balance.

There are a number of commentators, some more respectable than others, who believe we are about to enter an economic ice age. In other words, they believe that current low or negative real yields do indeed portend a bleak future.

Or do they?

Economic theory also says that the long-term interest rate is the rate required to keep saving and investment in balance. If you want to live within your means i.e. save, you need there to be someone, somewhere in the world, who wants to live beyond his i.e. invest. Oscar Wilde had great disdain for the former, saying “anyone who lives within their means suffers from a lack of imagination.” While one may not like Donald Trump, he and like-minded individuals who over the centuries have persuaded banks to lend them vast sums should be thanked for helping to boost economic activity and thus prop up savings rates.

It must be infuriating for many that their savings accounts are not yielding much (anything!) at the moment (even more infuriating for those who take inflation into account and realise that their savings are being eroded in real terms). However, these low yields reflect an abundance of those wishing to save and a dearth of those wishing to invest. The best way for savers to get better yields on their savings accounts would be to stop saving and start investing. This would boost the economy, and force central banks to put up interest rates!

The situation is not helped by governments that are worrying about their balance sheets when the clear message from bond markets is that they needn’t. Furthermore, large swaths of sovereign bonds are owned by central banks, and arguably should not be included in debt-to-GDP calculations.

Governments should instead be taking advantage of the low or negative long-term interest rates. As renowned economist Paul Samuelson famously observed, at a permanently zero or subzero real interest rate, it would make sense to invest any amount to level a hill for the resulting saving in transportation costs (1)

To be fair, there are tentative signs that the UK government is getting the message. In 2013 the Treasury issued a 65-year linker with a coupon of 0.125%, receiving a price at auction of 99.37% of par. In March of this year it issued a new tranche of £350 million at a price of 184%. The bonds are currently trading at 249%!

If the proceeds are spent on useful (or even useless!) public works projects, the benefits will be clear. First, there is a multiplier effect attached to public works spending that will boost economic activity well beyond the value of the projects themselves. Second, there will be a boost to private sector confidence. If companies and households see the government stepping in to support the economy, they should themselves be encouraged to invest.

However, it seems to have taken interest rates falling to where they did for the government to have woken from its slumber. In other words, low interest rates are what has been required to stimulate spending and investment and thus secure a rosier outlook.

While both theories about the relationship between growth and interest rates can be argued logically, the debate can be decided once and for all by looking at real world experience. If prevailing real interest rates reflect future economic prospects, there should be a strong and positive statistical correlation between real interest rates and equity returns.

There isn’t.

Regressing forward 20-year real total US equity market returns against prevailing US real bond yields, one finds no correlation at all. In fact, if anything, the correlation is very slightly negative (see chart). This is exactly what one should expect if bond yields tend to do whatever they need to in order to keep growth going.

Chart: The relationship between bond yields and equity returns

Chart 1 - PE Investment Letter - November 2016

Source: Bloomberg, Seneca IM

The implications of this are far reaching. First, one perhaps needn’t be as bearish about the longer term prospects for equity markets as safe haven bond yields suggest one should be. Second, one needn’t be so worried about companies with large pension fund deficits if they are using Gilt yields to discount liabilities, as is common practice. After all, why should a pension fund’s equity holdings be expected to grow in real terms in line with the current long-term real Gilt yield of -1.6% if there is no evidence that they should?

That’s also an interesting question.

 


(1) http://larrysummers.com/2015/04/01/on-secular-stagnation-a-response-to-bernanke/


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 1: Current fund tactical asset allocation (TAA) target weights as of 31 October 2016 (prior month’s targets in brackets)

Table 1 - PE Investment Letter - November 2016

  • Funds remain overweight equities in relation to strategic asset allocation in the belief that global credit cycle has further to run as well as valuations that remain below historic peaks
  • Tentative signs of economic growth stabilising or picking up, both in developed and developing countries

SDIF

  • Reduction in UK Equities target for the income fund related to reconciliation with actual position rather than a change of view
  • The position in Liontrust Asian Equity Income Fund was sold and switched into Aberdeen Asian Equity Income Fund, a closed end fund trading on a discount to net asset value
  • Pictet Emerging Currency Debt Fund was sold and reinvested into the existing holding in Templeton Emerging Markets Bond Fund, which offers a higher yield
  • The position in LondonMetric Property, a UK listed REIT, was increased following price weakness post the Brexit vote; we believe the active property management approach pursued by the manager remains attractive and is likely to add value in a more difficult market environment
  • The holding in SQN Asset Finance Income Fund was reduced due to our concerns over the quality of certain assets held and with the shares trading on a premium to net asset value

SDGF

  • Oxford Instruments exited – balance sheet is manageable, but more levered than desirable in post Brexit world with limited forward order visibility
  • Increased weighting to Twenty Four Monthly Select Income at a discount to NAV and reduced Royal London Short Duration Bond Fund. Potential for stronger absolute returns from former, given dislocation in credit markets, post Brexit, and defensive nature of short duration strategy.
  • SQN Asset Finance Income Fund was significantly reduced, due to our concerns over the quality of certain assets held within its portfolio and because the shares trade at a substantial premium to NAV

SGIT

  • Several UK equity mid-cap holdings were ‘topped-up’ including International Personal Finance, Senior, Ultra Electronics and Britvic
  • The position in Liontrust European Enhanced Income Fund was increased to maintain exposure to European equities
  • Japanese equity exposure was reduced via a top slicing of the Goodhart Michinori Japan Equity Fund; the fund had returned over 30% over the past year
  • Some switching was carried out within Asian equity fund holdings to consolidate positions
  • Property exposure was increased, primarily by adding to the position in LondonMetric Property, a UK listed REIT, where the manager’s active approach to property management will, we believe, add value in more difficult market environments
  • The holding in SQN Asset Finance Income Fund was reduced due to our concerns over the quality of certain assets held as well as the shares’ premium to net asset value

 


Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.10.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested.
This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/200.

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Peter Elston’s Investment Letter – Issue 18: October 2016

26 October 2016

It’s time to do something about high wealth and income inequality

High wealth inequality is being increasingly cited as one of the main causes of the structurally lower growth that much of the world, particularly the developed world, is currently experiencing. There is both good empirical as well as theoretical support for this relationship, suggesting that policymakers would be wise to start finding ways to lower wealth inequality.

Economic inequality has tended throughout history to be the number one cause of uprisings and revolutions (1) which are not on the whole great for incumbent elites (though they have been great for the likes of inventor of the guillotine, Antoine Louis! (2) ).

In the modern day of course, it is the ballot box that politicians fear. In this, the rise in anti-establishment sentiment around the world is something political and economic elites should take note of.

Why is economic growth currently so slow?

Secular stagnation thesis proponents such as former US Trade Secretary Larry Summers suggest that the low growth currently plaguing the world is due to factors such as falling population growth and the decline in demand for debt-financed investment. With respect to the latter, he noted in a speech entitled Secular Stagnation, Hysteresis, and the Zero Lower Bound (3) , “Ponder the fact that it used to require tens of millions of dollars to start a significant new venture, and significant new ventures today are seeded with hundreds of thousands of dollars. All of this means reduced demand for investment, with consequences for equilibrium levels of interest rates.”

He also suggests that high wealth inequality is a major reason for the low growth. In the same speech, he noted that, “changes in the distribution of income, both between labour income and capital income and between those with more wealth and those with less, have operated to raise the propensity to save, as have increases in corporate-retained earnings.”

The point here is that when wealth becomes concentrated in the hands of a small number of individuals, companies or countries,you get a glut of savings. The flipside of a savings glut is a shortage of demand, which means weak economic growth.

Economic growth relies on there being as many people, companies and governments willing to live beyond their means as there are those wanting to live within theirs. Right now, vast surpluses have been accumulated by an increasing number of billionaires (4), and companies such as Apple, Microsoft and Alphabet (5), as well as countries such as China, Germany, Japan and South Korea (6).

Turning to the empirical evidence linking wealth inequality with weak growth, it may be useful to look at the link between levels of indebtedness and economic growth. Arguably, it is more intuitive that high levels of indebtedness impede economic activity. At an individual level, the more debt you have, the less able you are to spend, and the less you spend, the less you contribute to economic growth.

This works at a country level too. As can be seen from the chart below, over the last one hundred years or so, there is a reasonably close inverse relationship between the level of debt to GDP in the US and the long-term (20 year) average of real GDP growth.

Graph 1 - PE Investment Letter - October 2016

The rising level of debt to GDP in the 1920s seems to have preceded the very low growth experienced in the 1930s, while the sharp fall in the 30s and 40s appears to have enabled the higher growth of the 40s and 50s. Furthermore, the rise in debt to GDP seen since the 1970s has gone hand in hand with GDP growth falling from above 4% towards 2%.

The relationship between levels of indebtedness and wealth and income inequality is somewhat less intuitive but just as strongly supported by actual experience, as can be seen in the chart below.

Graph 2 - PE Investment Letter - October 2016

Together with the first chart, one does not need to be Sherlock Holmes to deduce that there is an empirical link between income inequality and growth.

For me, the best way to better understand issues like income and wealth inequality is to put them in the context of a system made up of two people, then make extreme assumptions (I remember in my younger days watching Warren Buffett do this to explain trade and it left a lasting impression.)

So, imagine an economic system (society) made up of two agents (people) named Thrifty (T) and Spendthrift (S). There are only five economic activities undertaken in their society: house building, farming, papermaking, ink manufacturing and fishing equipment making. However, T is the sole provider of all of them. He provides shelter (including roof repair services) and food to S, and in return receives IOUs (yes, using T’s paper, T’s ink and a quill made from a feather kindly donated by one of T’s chickens).

Why S is so inactive could be for a number of reasons. It could be because T is so much better – more efficient – than S is at the aforementioned activities. It could be because T would rather hoard IOUs than buy from S. It could be because S is somewhat indolent, very tempting if you can just sign bits of paper then go fishing (yes, you got it).

Whatever the reasons for S’s inactivity, the upshot is that T becomes very wealthy, having amassed piles of IOUs. Wealthy on paper that is. Literally.

As for S, he ends up heavily indebted. The wealth inequality could not be more extreme! The question is, what happens when T starts to wonder what his IOUs are worth?

He can’t spend them because there is nothing to buy (S doesn’t have anything to sell). Instead, he reduces his sales to S so he can reduce the rate at which he is amassing what he has realised are effectively worthless bits of paper. Reduced sales of course mean reduced production. And another word for ‘reduced production’ is ‘recession’. Indeed, since the whole process of rebalancing this two agent economy – providing S with skills needed to start being productive – is such an involved one, it could even mean ‘depression’.

In the real world, while there are pockets of economic egalitarianism such as Germany and Japan, there are many large countries, both developed and developing, that have seen wealth and income disparity rising at a fast pace in recent decades and reaching what may well be unsustainable levels. Furthermore, while a number of developing countries have been catching up with their developed counterparts in terms of GDP per capita, there are others that have gone backwards.

It is possible, however, that it is hard to reverse wealth and income inequality that has risen to unsustainable levels. History has taught us that while the free market system is not perfect, is has tended to produce stronger and more sustainable growth than in other systems. Allowing the abler and more enthusiastic members of society to get richer than others has on the whole lifted standards of living for the less able too.

But, there is a flaw.

If you acquire wealth, you are very likely to want to do anything within the law to increase your wealth further.

Indeed, why wouldn’t you, either as a company or an individual, make political donations or employ lobbyists in the hope of for example encouraging favourable changes in tax codes? Oxfam head of research Ricardo Fuentes-Nieva, notes that the wealthy “get more resources to influence even more on how the tax code is modified, and thus lock the gains and protect the trend that mostly benefits them” (7).

Now, it can be argued that as long as quality of life is at least maintained for lower income groups, it doesn’t really matter how high inequality rises. We live in a world in which the time it takes to make a billion is declining rapidly – I imagine it took Mark Zuckerberg a tenth of the time it did John D Rockefeller. As long as our quality of life is maintained, should we care how many billionaires there are on this planet?

Yes, we should. And not only because rising inequality means too much debt which leads to lower growth. Human nature is such that we care more about relative wealth than absolute wealth. It doesn’t matter if our quality life is maintained if we see others doing better than us – also known as ‘not keeping up with the Joneses’. This phenomenon has been observed in studies such as that by Prof Christian Elger and Prof Armin Falk at the University of Bonn (8).

The dissatisfaction that results from feeling left behind economically is what is behind the rise in support for non-mainstream politicians such as Donald Trump, Jeremy Corbyn and Marine Le Pen. The so-called political elite would be well advised to start finding ways to reduce inequality.

The big question is, can they?

 


(1) https://www.reference.com/history/common-causes-revolution-history-d022271ee8d15436
(2) https://en.wikipedia.org/wiki/Guillotine
(3) http://larrysummers.com/2014/06/23/nabe-speech-u-s-economic-prospects/
(4) http://www.forbes.com/sites/timworstall/2014/10/30/oxfams-new-report-number-of-billionaires-has-doubled-since-the-crash/#551edd7dfbd5
(5) http://www.usatoday.com/story/money/markets/2016/05/20/third-cash-owned-5-us-companies/84640704/
(6) https://en.wikipedia.org/wiki/List_of_countries_by_current_account_balance
(7) http://policy-practice.oxfam.org.uk/blog/2013/09/tax-rates-and-the-top-1-percent
(8) http://www.telegraph.co.uk/news/science/science-news/3315638/Relative-wealth-makes-you-happier.html


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 1 - PE Investment Letter - October 2016

  • No changes to top down target asset allocation in September
  • Funds remain overweight equities and underweight safe haven bonds, in the belief we are generally at the point in the business cycle when inflation rises (bad for bonds) but employment continues to rise (good for equities)
  • SDGF’s holding in the Bellevue African Opportunities Fund was sold, with the proceeds being allocated to existing holding Somerset Emerging Markets Dividend Growth Fund; this change was last within overseas equities that related to the restructuring of the fund away from specialised funds towards more general fund
  • GCP Student Living was sold from both SDIF and SDGF on the basis that share price strength had pushed down the yield to less attractive levels; proceeds were allocated to Aberdeen Private Equity Fund
  • In UK Equities it was decided to sell Ashmore and move the proceeds into Ultra Electronics; Ashmore had risen 75% from its January low and as a result its valuation had become unattractive while Ultra Electronics, already held in SDGF, was generating a dividend yield that made it appropriate for SDIF and SIGT
  • Towards the end of the month, our UK Equity specialist Mark recommended the purchase of Phoenix Group, already held elsewhere, for SDGF, believing that the Abbey Life deal was transformational and leaves the shares
  • Units of the iShares UK Dividend ETF were sold to finance the purchase

 


Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 30.09.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested.
This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/182.

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Peter Elston’s Investment Letter – Issue 17: September 2016

6 September 2016

An interesting essay by San Francisco Fed President, John Williams

Having written about secular stagnation and the natural rate of interest in my August letter, it was interesting to see San Francisco Fed President, John Williams, write about low natural interest rates in his latest Economic Letter. I’m no expert, but it seems to me that Williams is the leading authority on the subject, having written a seminal paper (1) alongside colleague, Thomas Lauback, back in 2001. Therefore, I think he’s worth listening to.

Indeed, his conclusion is an appeal to central banks and governments to “share responsibilities” [for boosting growth]. He goes on to invoke Machiavelli, suggesting that “we can wait for the next storm and hope for better outcomes or prepare for them now and be ready” (one wonders to what extent his essay swayed opinion at the Jackson Hole Symposium).

To recap, the natural rate of interest is essentially the rate that keeps inflation stable. It has nothing to do with monetary policy and everything to do with structural factors such as demographics, trend productivity and economic growth, emerging markets reserve accumulation as well as general global demand for savings. Williams points to the decline in the natural rate of interest to what are now very low levels over the past quarter century and considers what can be done to increase it. As should be evident, the prevailing natural rate of interest reflects future economic growth prospects, which is why it is so important for investors.

It is a shortage of private investment demand in combination with an oversupply of savings that has caused the natural rate of interest as well as long-term real bond yields to fall as far as they have. In the developed world, it seems to me, private investment is weak either because population growth is low, because economies are already advanced, or because there is no new productivity busting technology out there (past examples include the plough, the steam engine, the internal combustion engine and the computer). There isn’t much we can do about the first two, but governments should be doing everything they can to encourage the commercialisation of new productivity-busting technologies (please excuse the pun, but driverless cars should be getting a smoother ride). Furthermore, in the absence of strong private investment, surely there is a strong case for a big increase in public investment, particularly in infrastructure.

In a critique of Williams’ essay (2), former US Treasury Secretary and proponent of the secular stagnation thesis, Larry Summers, suggests that Williams does not put enough emphasis on infrastructure investment as a means of stimulating growth and thus raising the natural interest rate. Summers is convinced that debt-financed infrastructure investments pay for themselves, essentially as a result of multiplier effects (economist Philip Milton received rapturous applause when he suggested similar on BBC’s pre-Brexit Question Time (3)). Williams does write that, “returns on infrastructure and research and development investment are very high on average”, though it seems Summers wanted him to be much bolder.

As for the savings glut, while developing countries seem intent on accumulating safe haven bonds, this is not the only problem. Take the savings industry in the developed world, for example. In many respects, allowing companies to close defined benefit pension schemes was one of the biggest mistakes ever made by governments. If you are saving for yourself rather than in a pool with others, you are naturally going to over-save. I am guilty of this myself as I believe I have to assume that I and/or my wife are going to live to 110. We are both hopeful that we will be gone by 90, but we have to assume the worst. Scale this behaviour up, and the resulting increased demand for savings is a huge drag on economic growth. As Oscar Wilde said, “Anyone who lives within their means suffers from a lack of imagination”.

To illustrate just how damaging the abandonment of pooling with respect to pension savings has been, imagine if we did the same for another industry where pooling is central: insurance. The idea of insuring yourself is of course absurd.

Let’s hope that in the not too distant future governments can start applying some common sense either with respect to infrastructure investment, putting more incentives in place with respect to new technologies, or discouraging over-saving.


(1) Measuring the natural rate of interest https://www.federalreserve.gov/pubs/feds/2001/200156/200156pap.pdf
(2) http://larrysummers.com/2016/08/18/6937/
(3) https://www.youtube.com/watch?v=0dUUDFTFzOo


 

Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 1: Current fund tactical asset allocation (TAA) target weights (as of 31 August 2016, prior month’s targets in brackets)

Table 1 - PE Investment Letter - September 2016

  • We reduced the equity targets for all three funds by 2 percentage points in light of recent strong market performance
  • Reductions came entirely out of Europe ex UK; although the region has underperformed over the last year or so, our level of conviction has decreased somewhat following the Brexit vote and the political difficulties it exposed
  • We remain 3 percentage points overweight in Europe which reflects the decent yields on offer both in absolute terms and in relation to history
  • Furthermore, Europe’s business cycle has further to run than in the UK and US, thus there remains better potential for earnings to rise
  • As for use of target proceeds, 1 percentage point went into cash and 1 percentage point to Specialist Assets
  • We will consider uses for the 1 percentage point cash in the coming weeks as opportunities arise
  • As for the increase in Specialist Assets, the 1 percentage point was spread across eight existing holdings within REITs, Specialist Financial and Infrastructure

SDIF

  • Profit was taken on several UK equity holdings bought at much lower levels in the market falls post the Brexit vote
  • The Essentra position was increased following price weakness on CEO leaving announcement
  • The position in Schroder European Alpha Income was sold to reduce overall exposure to European equities
  • Baillie Gifford High Yield Bond Fund was sold – switched into Muzinich Short Duration High Yield to improve portfolio income
  • We increased investment in Royal London Sterling Extra Yield Fund, Royal London Short Duration Global High Yield Fund and Twenty Four Select Monthly Income Fund, to further consolidate holdings

SIGT

  • Several UK equity holdings were top sliced – taking profit on purchases made in the market sell-off post Brexit
  • The holding in Essentra was increased following price weakness on announcement of CEO departure
  • Schroder European Alpha Income Fund was sold to reduce exposure to European equities
  • We purchased Invesco Perpetual European equity Income Fund to increase emphasis on Value managers, which was partly funded by reduction in Blackrock Continental Income Fund
  • US equity holdings were consolidated with sale of IShares MSCI USA Dividend ETF – switched into existing holding in Cullen Global North American Dividend Value Fund

SDGF

  • Consolidated European and Japanese holdings down to two in each geography, thereby increasing weighting to Invesco Perpetual European Equity Income Fund and Goodhart Michinori Japan Equity Fund
  • We significantly reduced our holding in the Polar Capital Biotechnology Fund on strength, with a view to ultimately exiting sector specific funds. The proceeds were invested in the iShares MSCI USA Dividend IQ UCITS ETF, pending the completion of due diligence on a new active manager

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.08.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested.
This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/155.

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Peter Elston’s Investment Letter – Issue 16: August 2016

8 August 2016

Secular stagnation and the natural rate of interest

One of the most interesting features of global financial markets over the last 20 years has been the inexorable decline in long-term real interest rates (see chart below of yields of index linked bonds of maturities over five years across various developed markets). As is evident, this is a global trend, though not all countries have 20 years of history.

Chart 1: Index linked bond yields (maturities over 5 years)

Chart 1 - PE Investment letter - August 2016 Source: Bloomberg, Seneca Investment Managers

The decline has reignited the debate about ‘secular stagnation’, a term coined in the late 1930s by American economist Alvin Hansen to refer to the feeble recovery in the US economy that followed the Great Depression. Hansen argued that weak trends in population growth and technological innovation meant that the low growth would continue for many years.

That there is a vibrant debate about whether global growth is stagnating or not is itself instructive, as it suggests the study of economics has not advanced much in recent decades – surely we should know the answer to this question! Earlier this year, Prospect Magazine (1)  ran a series of four articles on the subject, two by proponents of the stagnation thesis and two by opponents. They were all written by well-respected economists, and consequently all were persuasive.

The economists arguing in support of the stagnation thesis were former US Treasury secretary Larry Summers and Northwestern University professor Bob Gordon. Representing the other side of the debate were GaveKal co-founder Anatole Kaletsky and University of Illinois at Chicago professor Deirdre McCloskey.

Of the four articles, I found Anatole Kaletsky’s the most convincing. Here is an excerpt:

“Cuts in public spending and tax hikes, motivated by irrational paranoia over public borrowing, have been so severe that it has not been possible to offset their effects through low interest rates. Inadequate demand, combined with labour deregulation and globalisation that would have been healthy if conditions had been normal, have squeezed wages downwards, reducing incentives for investment and aggravating inequality, which in turn has exacerbated the weakness of consumer demand. 

“To make matters worse, inflation is systematically exaggerated in official figures. If the true level of inflation since 2008 has been negative, as appears quite likely, then even zero interest rates were too high to stimulate rapid growth.”

In Kaletsky’s world, the fall in long term real interest rates in recent years was indeed the result of lower growth but this lower growth, particularly since the Great Financial Crisis, was due to cyclical factors (poor monetary and fiscal policy) rather than structural ones.

On the subject of structural factors such as innovation, Kaletsky sees evidence of technological progress everywhere. Robert Gordon, on the other hand, “assumes that the weak economic statistics are proof that, however much new technology we see around us, progress has slowed down.” I can’t help but side with Kaletsky, seeing as I do the extraordinary ways in which our lives continue to be made better, whether with respect to medical advances, battery storage, energy production, car and airline safety, or online shopping.

That being said, it does not appear likely that governments are going to change course with respect to public spending policy any time soon, and instead will continue to pander to growing protectionism within their electorates. This may well mean that economic growth in the medium term continues to weaken.

In such a world, one can either accept the resulting lower returns from bonds and equities, and the lower future consumption that they imply, or one can try to achieve higher returns by investing more actively – seeking out those areas of equity markets such as smaller companies or certain emerging markets that are likely to perform better over time. We would strongly espouse the latter.


(1)     http://www.prospectmagazine.co.uk


A proposal for the British government

I have a proposal for the British government. It’s not complicated: sell vast quantities of 50-year debt and buy vast quantities of UK equities.

In late July, the Treasury sold £2.5 billion of debt for £5.1 billion. During the lifetime of the bond it will have to pay a total of £0.2 billion in interest but this isn’t much in the grand scheme of things. Let’s say the Treasury sensibly puts this to one side and is left with £4.9 billion. Surely it can find something to do with this over the fifty years. If it can make a return on investment of at least -1.4%, then it will have the funds to repay the £2.5 billion par value.

You may have realised that I am referring to the most recent tranche of the 0.125% 2065 inflation linked Gilt that was sold on 26 July for 201.335% of par. In other words, the aforementioned return of -1.4% required to pay back the bond at maturity is a real return. You could just as easily use a nominal bond and a nominal required return. However, using the inflation linked Gilt makes it easier to understand the point at hand, namely that current yields imply the government cannot make a real return on investment of even -1.4%. (At this point I am reminded of economist Paul Samuelson’s famous remark that at a permanently zero or subzero real interest rate it would make sense to invest any amount to level a hill for the resulting saving in transportation costs.)

Back to my proposal: surely a basket of UK equities will return more than -1.4% per annum over the next fifty years?

They are already yielding 4.1%, so you’d need corporate earnings – and thus dividends – to fall 5.5% per annum in real terms over the long term for total annual real returns to equate to -1.4% (note: this derives from a mathematical truism that says that total return is equal to the dividend yield plus the growth in dividends, otherwise known as the Gordon growth formula). Even if we say that dividends are currently twice the sustainable level, and start with a 2% yield, we’d still be left needing earnings growth of just -3.4% per annum.

Now, earnings and dividend growth over time tend to be around two percentage points per annum less than GDP growth (note: this is because listed companies are generally the larger ones and thus have less propensity to grow than the average company). So, even if we assume an immediate and permanent 50% cut in dividends, GDP growth for the next 50 years could shrink 1.4% per annum and the British government would still break even.

Can economic prospects really be that bad? It’s possible, I suppose, but unlikely.


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 1: Current fund tactical asset allocation (TAA) target weights (as of 31 July 2016, prior month’s targets in brackets)

Table 1 -PE Investment Letter - August 2016

  • No changes to tactical asset allocation during the month.
  • Both Sterling and Gilt yields stabilised, following June’s sharp falls.
  • Equity markets around the world performed well, with markets responding well to strong July payrolls in the US that suggested the US economy was still growing at a moderate pace.
  • It is becoming clear that Brexit has impacted household and business confidence that will likely merit a response from the Bank of England.

SDIF

  • The holding in the AXA US Short Duration High Yield Bond Fund was sold to further consolidate holdings, with the yield on the fund having fallen to a less attractive level.
  • The fund’s position in the TwentyFour Dynamic Bond Fund was reduced to provide funding for an increase in the TwentyFour Select Monthly Income Fund, which offers a higher yield.

SIGT

  • Royal Dutch Shell was exited following a significant re-rating which led to a premium PE and yield compression.
  • New investment in IShares FTSE UK Dividend Plus which maintains UK equity weighting pending further work being carried out on a new direct investment.
  • Added to position in Polypipe following Brexit related sell-off.
  • Top sliced Asian equity holdings to maintain weighting following strong performance this year.
  • New investment in International Public Partnerships in order to broaden the exposure across a range of infrastructure sectors. This was funded with a managed exit from Bluefield Solar Income Fund which has a narrower mandate.

SDGF

  • Initiated a position in Intermediate Capital, manager of alternative credit strategies. Strong growth in permanent capital AUM. Yield over 4%.
  • New investment in Dairy Crest. Cathedral City increasing market share. Yield over 4%, improving cash flow and returns, post disposal of dairy business. Premier Foods being exited.
  • Royal Dutch Shell exited. Significant re-rating – premium to NAV and yield compression.
  • Atlantis China Healthcare Fund exited, favouring regional manager, Stewart Investors.
  • New investment in Aberdeen Private Equity Fund on unwarranted discount to NAV as well as strong NAV growth.

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.07.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested.
This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/137.

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Peter Elston’s Investment Letter – Issue 15: July 2016

18 July 2016

Recent fund performance

Since the referendum, our funds have slipped down the peer group rankings. This does not mean that their absolute performance has been particularly poor, just that the funds have underperformed their respective peer groups in recent weeks. While many will understand that poor short-term performance relative to peers – as well as in absolute terms – may happen from time to time, there may be others who are not so comfortable. The following will I hope provide reassurance.

Our funds are diversified in that they are spread across equities, bonds, and specialist assets. However, we are value investors and so are trying to capture the medium- to long-term price appreciation of financial assets that results from their value being under-appreciated. This is why we have a mid-cap focus in the UK – investors tend not to fully understand the scope for smaller companies to grow, so their share prices as a group tend to perform better.

As value investors we are also seeking to avoid financial assets whose value we think is being over-appreciated. This is why we do not hold developed world government bonds, which even before recent events were expensive – buy the 30-year inflation Gilt today and hold it to maturity and you are certain to lose a third of your real capital at today’s rates.

While we continue to have absolute confidence in our positions with respect to mid-caps focus and government bonds, both have hurt our peer-relative performance over the last 2-3 weeks. It should also be noted that we have other positions that have performed well or held up over the same period.

Many of our competitor funds own expensive Gilts or US Treasuries and avoid under-appreciated smaller companies. Such positioning will naturally – and indeed did – aid short-term performance but it will also very likely lower their longer-term returns. We think it is longer-term performance that is more important. In fact, given increasing longevity, paucity of value in bond markets, as well as low growth generally, we think it is more important than ever to focus on longer-term performance. The harsh reality of this however means having to accept the odd period of poor short-term performance, whether in absolute terms or relative to peers.

Our mid cap focus in the UK has been the major cause of the recent poor short-term fund performance in relation to our respective peer groups. However, we are very careful about what we buy, placing great importance on balance sheet strength and profitability. This we believe will help to produce good performance over time in relation to both mid-cap and large-cap indices and thus counter the impact of periods such as the last few weeks when mid-caps fell off sharply. Furthermore, we don’t own too many mid-caps, so we know them extremely well. Here are a couple of examples.

Kier Group is a conservatively managed vertically integrated construction and services company. Despite the fact that 85% of revenues in its two largest divisions are already covered by existing orders out to June 2017, the shares have been weak and now yield 7%. The dividend is well covered by earnings and supported by a strong balance sheet. Recent acquisitions of May Gurney and Mouchel provide considerable scope for further expansion, as cross-group revenue synergies are explored. Meanwhile, the company should also benefit from rising infrastructure spend which has cross-political party support. Specifically, the Highways Agency’s £17bn ring-fenced budget for its Road Investment Strategy and the National Infrastructure Commission’s £100bn budget out to 2020 provide tailwinds.

Victrex manufactures polyether ether ketone (PEEK), a high performance polymer that possesses unique qualities, such as being ultra-lightweight, extremely strong, resistant to chemicals and extreme temperatures, and is also electrically conductive. The company has dominant market positions and is frequently finding new uses for PEEK, due to its constant drive for innovation and ongoing collaborative work with its customers. Over 90% of Victrex’s revenues are from outside the UK, therefore it is a big beneficiary of sterling weakness. The shares yield over 3% and the dividend has grown by over 13% p.a. over the last 10 years. The company has net cash on the balance sheet and has stated that it intends to return surplus cash back to shareholders by means of special dividends.

Elsewhere in the funds, while we have some currency-hedged overseas equities funds, most are unhedged so have performed well as a result of the weakness in the pound. As for our fixed income funds, their prices have generally remained stable, though they have not of course performed nearly as well as safe haven bonds.

Of interest we think is the performance of some of our specialist assets. As a reminder, these on the whole are investment trusts that invest in income generating assets such as aircraft, property, medical equipment, loans, mortgages, and infrastructure. Again, we are very careful what we buy and, because we don’t own too many of them, we monitor them closely. We are looking for income streams that are stable and index-linked. We are looking for decent yields. These attributes have served some of our specialist assets holdings particularly well in recent weeks. Here is one example.

Primary Health Properties is a REIT invested in predominantly UK based purpose built modern GP surgeries and medical centres. It has a very secure tenant (NHS plus ancillary services), a visible and growing income stream, and resides in a property sector that requires substantial increases in investment.  The attractions of such low volatility tangible value are thus clear. The investment pays us a fully covered and growing dividend yield of 4.6%. At the time of writing (5th July) the shares are trading where they were prior to the referendum vote and have displayed none of the stresses experienced elsewhere in the property sector.

To conclude, we continue to have complete confidence in our process and in the capacity of our funds to generate value over the longer term. We place a great deal of importance on the quality of businesses we own and making sure that third party managers we engage have a similar mindset.


Brexit

There is much that can be written about the referendum result. Indeed, much already has been. I shall try to keep this simple and focus on what, I believe, are the two key questions for our investors and ourselves. One, what were the prospects for the UK and global economy before the referendum? Two, what has changed since?

For the last few years, growth in the UK and globally has been OK but not great. My view was that things were likely to continue in this vein rather than growth recovering to pre-crisis levels or on the other hand it slipping into negative territory.

I had a number of reasons for believing the global economy would continue to grow. First, that is its tendency. Despite the tiny minority who would like to return the human race to the Stone Age, most of us conduct our daily lives in a constructive way, both providing as well as consuming products and services. Aggregate that at a systemic level and you have what is called growth. And it’s quite hard to stop that in its tracks because, well, it’s what we like to do.

Since we quite like being constructive, we tend to do it more and more until economies overheat and central banks feel the need to step in and end the party. Looking at inflation prior to last Thursday, it seemed clear that economies on the whole were far from overheating. Agreed, some were closer than others, but at a global level it was obvious that there was a still a chronic shortage of demand rather than an excess of it.

Former US Treasury Secretary Larry Summers has written about this “chronic” demand shortage. He refers to it as secular stagnation – a term coined by Alvin Hansen in 1938 to describe what he feared the US economy was experiencing in the aftermath of the Great Depression. In fact, I was going to write about Summers’ deliberations on the subject in detail in this investment letter. Alas, Brexit has rather overtaken events and that shall have to wait. Nevertheless, Summers’ key conclusion is that secular stagnation is real but that it can be countered with public investment in areas such as infrastructure. Since fiscal austerity has not generally resulted in a strong recovery in private sector confidence, he argues, it should be stopped. Furthermore, econometric models suggest, he says, that although government borrowing as a percentage of GDP would at first rise, over time it would fall as the multiplier boosted the denominator, GDP.

I have had increasing sympathy with this argument and as a result felt more optimistic about the prospects for the world economy. That said, it will likely be a while before key policymakers listen to Summers – and the many others who share his views – and consider his proposed solution.

In the meantime, I believed that ultra-loose monetary policy would prevent demand from falling off a cliff while workforce slack would prevent inflation from rising to uncomfortable levels.

My somewhat hopeful view was supported by generally positive leading indicators, yield curves that were steep rather than inverted, as well as the aforementioned low inflation and labour force slack.

Then on 23 June Britons voted to leave the EU. What has changed as a result?

The most obvious and incontrovertible thing that has changed is that the referendum is now behind rather than ahead of us. This matters because the UK and European markets had been weak over the preceding year or so, arguably because the referendum lay ahead and represented uncertainty (in the 12 months to May 2016, outflows from all IA sectors totalled £38 billion). True, there are now other uncertainties that have taken its place but at least they are not binary in the way markets hate.

Another equally incontrovertible fact is that the ‘leave’ camp won the referendum. The market’s violent reaction suggested this result was both unexpected and perceived as negative for the UK economy, though equities have since recovered. It seems the most likely outcome is that at some point the British government triggers Article 50 of the Lisbon Treaty, thereby setting in motion the process to leave the EU. But it is far from clear when – and perhaps even if – this will happen.

In the meantime, there is scope for all sorts of developments. One of these must be for Brits to ponder whether the UK should seek to remain in the single market. If yes, we would have to accept free movement of people as Norway and Switzerland have. If no, we would have to accept tariffs on trade in goods and services with the EU. New UK Prime Minister, Theresa May, has said, “It must be a priority to allow British companies to trade with the single market in goods and services — but also to regain more control of the numbers of people who come here from Europe.” This is all very well, but the EU has made it clear that the UK cannot have both.

The pound has fallen sharply. In some respects, this is a good thing as the UK’s current account deficit as a percentage of GDP had reached an unsustainable 7% 1 (see chart 1). That said, the initial effect of the pound’s weakness will be to widen the deficit even further as imports cost more and exports are worth less. Longer term, the fall in the currency will be stimulative, though how much spare capacity the UK economy has to absorb this stimulus is unclear. Although wage pressures remain relatively subdued, Bloomberg Intelligence’s estimate of the UK’s output gap suggests that much of the excess capacity that prevailed after the Great Financial Crisis has now been removed (see chart 2).

Chart 1: UK current account deficit as % GDP

Chart 1 - UK current account deficit as a % GDP

Chart 2: UK output gap (%)

Chart 2 - UK output gap %

Bond yields have fallen sharply. As of 4 July, the yield on the 10-year Gilt stood at 0.83% compared with 1.37% on the day of the referendum. Interestingly, this was not due to a fall in inflation expectations. Quite the opposite in fact – the inflation rate expectation embedded in 10 year yields actually rose following the referendum, from 2.31% to 2.34%. In other words, it was a fall in real yields rather than inflation expectations that drove the fall in nominal yields.

Putting this fall in real yields in a longer term context as well as in the context of equity market yields is particularly interesting (see chart 3). The yield of -1.503% on the 10-year inflation protected Gilt as of 4 July suggests that if you bought it and held it to maturity you would make a total real return of -14% (for the 30-year the number is -33%).

Chart 3: Long term yields

Chart 3 - Long term yields

Bank of England governor Mark Carney has hinted he’ll loosen monetary policy over the summer. Furthermore, former Chancellor, George Osborne, backtracked on his longer term budget targets. It is clear therefore that both the Bank of England and the Treasury expected the impact of Brexit on the UK economy to be negative, perhaps considerably so. At the same time, evidence of an immediate impact is sparse. As of 4 July there were only 22 items on the FT’s Brexit Business Impact Tracker, a log of the expected impact of Brexit through company announcements and similar. Given all the warnings from UK companies ahead of the vote, it is perhaps surprising there have not been more announcements of cuts of some sort.

Chart 4: Citi WGBI GBP hedged (inflation adjusted)

Chart 4 - Citi WGBI GBP hedged (inflation adjusted)

There are many other things that have changed since the referendum that I have not mentioned. However, the point of those that I have chosen to highlight is that it remains very unclear what the longer term economic impact will be of the vote to leave the EU.

What we do know is that developed market government bonds are even more expensive now than they were prior to the referendum (the chart above suggests that the great bond bull market is running out of steam but taking a long time to end!) We also know that equity market yields are generally well above long-term historic averages. Therefore, as far as the big asset allocation call between bonds and equities is concerned, this suggests pretty clearly that one should underweight the former and overweight the latter. We are thus sticking with our current positioning.


1  Average of Q4 2015 and Q1 2016


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 1: Current fund tactical asset allocation (TAA) target weights (as of 30 June 2016, prior month’s targets in brackets)

Table 1 - Current fund tactical asset allocation target weights - 30 June 2016a

  • No asset allocation changes in June
  • SDGF: we switched Prudential into Legal & General, after material outperformance by the former
  • Ocean Dial Gateway to India exited, following strong performance and a preference going forward for regional, rather than country specific exposure within Asia
  • Thomas Cook was exited to fund a new investment in Essentra, a global manufacturer and distributor of small but essential components, e.g. plastic screw caps, as well as health and personal care packaging
  • SDIF: we introduced two new names: Essentra and Arrow Global
  • The relative strength of fixed interest assets enabled us to fund the equity purchases with reductions in our two Royal London fixed interest funds. These sales followed reductions earlier in the month in emerging market debt (Pictet and Templeton)
    Strong performance through the month enabled us to take some profits from specialist assets, thereby releasing capital for other areas of undervaluation
  • SIGT: Holding in BHP Billiton was sold due to uncertain outlook for commodity prices and following recent cut in dividend
  • A new holding namely Essentra was introduced to the portfolio with the company having seen a significant derating following a profit warning in early June
  • Asian equity holdings were reduced following strong performance over recent months – bringing overall exposure back towards target weightings
  • Several specialist asset holdings were top sliced to provide funding for UK equity purchases

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 30.06.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested.
This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/118.

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Peter Elston’s thoughts on the Brexit vote – June 2016

24 June 2016

A comment on the Brexit decision

We wake up today to the extraordinary news that Britons have voted to leave the European Union. The immediate question is what the implications are for financial markets and for our funds.

First, although we did not discount the possibility of this outcome, nor did we think it the more likely. We believed that although the polls were close, undecided voters would tend to vote to remain. We were wrong.

Our funds are multi-asset funds so have some natural defensiveness built in via exposure to fixed income investments and what we call specialist assets, some of which are denominated in foreign currencies that will be rising today against a sharply falling pound. But within our multi asset framework we are still exposed to investments, principally equities, which will fall sharply today.

We have always communicated the message that we are long-term investors so our hope, and indeed our expectation, is that our investors will remain calm. As the saying goes, if you are going to panic, panic first. We certainly think it unwise to join any stampede and indeed at some point would like to take advantage of the lower prices.

Right now it is unclear how far and for how long markets will fall though it is quite possible that markets today will end the day well off their lows. Markets have a tendency to overreact. We will be watching very closely but remaining calm.

Further out, it will be the implications of voting to leave the EU for the UK economy that will continue to occupy our thoughts. It was patently clear from the debate that even those campaigning to leave the EU did not know precisely what a post-Brexit world would look like. The financial markets are sending a clear message today that it could well be bleak, though that is by no means a certainty. Indeed 52% of the electorate believes that the UK’s prospects are now brighter. They and their flag bearers should now be listened to.

 


Download this investment letter as a PDF


 

Important Information

The information in this document is as at 24.06.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Before investing in the CF Seneca Funds you should read the key investor information document (KIID) as it contains important information regarding the fund, including charges, tax and fund specific risk warnings and will form the basis of any investment.

The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the Fund (0845 608 1497). Seneca Investment Managers Limited, the Investment Manager of the Fund (0151 906 2450) is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/107

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Peter Elston’s Investment Letter – Issue 14: June 2016

21 June 2016

Active management and the problem with “passive”

My attention was drawn last month to a recent McKinsey report entitled, Diminishing Returns: Why Investors May Need to Lower Their Sights.1

The thrust of the report was that investors’ current expectations for future returns have been shaped by actual returns enjoyed over the last three decades. Since these were unusually high, expectations for the future are now too high. The report notes that high returns over the past three decades were due to sharp declines in inflation and interest rates; high GDP growth that was the result of positive demographics, productivity gains and rapid growth in China’s economy; and even stronger corporate profit growth due to such factors as declining corporate tax rates. Some of these trends, the report argues, have now either stalled or gone into reverse, meaning that future returns will be lower, perhaps considerably so, than they were in the past.

I have sympathy with the conclusion, and in fact would add the cost of climate change to the list of factors that will increasingly impact growth – and indeed aggregate corporate profits – in the decades ahead.

As an investor, one has two choices: one can either accept the lower returns or one can do something about it. Or, to put it another way, you can either ‘be’ the market by investing in passive funds that will simply provide you with these lower returns, or you can seek to ‘beat’ the market by investing actively, thus enhancing your returns if done successfully.

It is therefore ironic that flows into passive funds appear to be accelerating (see FT article, Passive funds grow 230% to $6tn 2) at a time when market returns are in decline. Furthermore, if you need to make your savings pot last longer because you are going to live longer, you are effectively doubling your problem by going passive.

This is not to say that I think beating the market is straightforward. It clearly isn’t, as the plentiful evidence that most actively managed funds fail to beat their benchmark indicates.

I am thus dismayed that, as the FT article cited above notes, active managers have been “attacked by academics and consumer groups for not offering value for money.” Of course active managers do not as a group offer value for money! The reality is that active investing is not like Blackjack in which it is possible for everyone to win, but Poker, in which some win necessarily at the expense of others. The above attack is the equivalent of criticising lotteries on the basis that the vast majority of participants win less (i.e. nothing) than they spend to play.

This analogy is not a perfect one, because winning lotteries is about luck. If financial markets were efficient, and it was thus impossible to beat the market, I can assure you my savings pot would be stuffed full of passives.

But they’re not.

The prices of financial assets do not move randomly but exhibit pattern, meaning that price movements are a function of previous movements and are thus predictable (unlike random movements which are by definition independent and thus unpredictable). This assertion is not opinion but fact – there are plenty of statistical tests that have found pattern in financial markets. For example, when real interest rates are high, real returns from bonds will tend to be high (the converse is also true). Another one: when the dividend yield of a higher quality company’s stock is higher than the market average, the stock’s total return tends to be higher than the market average. (Another name for the pattern at work here is mean reversion.)

However, taking advantage of these patterns is harder than it might appear.

First, it requires a contrarian mindset. The reason why dividend yields or interest rates become too high in the first place is generally that the companies or economies in question get into difficulty (think about falling oil prices over the last couple of years that drove up yields of oil majors or the high inflation of the 1970s that drove up interest rates). It takes a strong mind to see such difficulties as opportunities rather than as things to fear. Such strength is rare in any walk of life – most humans prefer to be part of a group rather than to stand apart from it. And of course we humans are emotional beings – being fearful is a natural trait that we evolved to protect ourselves from genuine threats such as sabre toothed tigers and disease. Human nature will per se always be hard for humans to counter.

Second, spotting patterns in markets requires a fair grasp of mathematical concepts that is also fairly uncommon. Computers are now bypassing humans in this endeavour, enabling the emergence of so-called smart beta funds that seek to take advantage of patterns such as value, quality and momentum. But there will always be some scepticism about putting your savings in the hands of computers, and thus mathematical nous will remain a valuable skill for so endowed active managers. Furthermore, smart beta funds themselves will likely by virtue of their buying and selling create other patterns that the skilled active manager can take advantage of. After all, any fund that invests according to a strict, and public, set of rules, whether traditional passive or smart beta, is essentially flagging to the world what it is about to do. It should be possible for active managers to work out how to profit from such knowledge.

Third, funds may become too big to be able to take advantage of market inefficiencies. Peter S. Kraus, chairman and chief executive of AllianceBernstein, recently wrote that, “Active equity managers as a group made two mistakes: one, as we grew quickly, we got complacent about our ability to effectively manage larger pools of assets. Then, with bigger portfolios to invest, many managers over-diversified their holdings as a way to reduce risk and preserve those assets.”3

I am reminded of Warren Buffett’s comment in a 1999 interview for BusinessWeek: “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”4

Now, I have an awful lot more to prove than Buffett, and I’d be thrilled if I had a fraction of his ability, but I do know three things:
1. our Seneca funds are sufficiently small to be able to take advantage of investment opportunities that are out of reach for our bigger competitors,
2. I suspect they can grow several-fold before this advantage begins to wear off, and
3. if and when we reach that point, I will be very conscious as to any trade-off between further growth on the one hand and capacity to produce good performance on the other to prevent us growing further.

After all, my duty of care is to our investors as well as our shareholders.


1  http://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/why-investors-may-need-to-lower-their-sights
2  As at May 29, 2016
3 FT article, Why the era of the ‘closet benchmarker’ has to end
4 As quoted in “Wisdom from the ‘Oracle of Omaha’” by Amy Stone in BusinessWeek (5 June 1999) https://en.wikiquote.org/wiki/Warren_Buffett


The UK referendum

First it was David Cameron, then it was Gordon Brown, now it seems the markets have taken over the lead role of campaigning to stay in the EU. As the likelihood of Brexit has risen in recent days and weeks, sterling and equity markets have tumbled while safe haven Gilts have risen, presumably an indication of just how awful a vote to leave would be. The question is, how many people will this message from the markets sway?

This is not about facts any more, though I’m not sure it ever was. No one knows whether it would have been better to have been outside the EU these last few decades. And no one knows whether it will be better or worse to stay in. No, it is now down to pure psychology: the extent to which voters are either scared of the unknown or prepared, enthused even, to leap into it.

At the time of writing, the betting markets have the probability of a vote to stay at just over 60%. This is despite recent opinion polls putting the leave campaign ahead by a couple of percentage points or so. In other words, the betting markets are saying that the polls are wrong.

It wouldn’t be the first time. Despite adjustments that the polling companies make to ‘raw’ polling data, there are certain things they can’t account for, at least not accurately. For example, which way will the large number of undecided voters swing? Second, as alluded to above, to what extent will voters take note of the fears that are being very clearly expressed in financial markets? Third, voters may well express an opinion that is based on principle when polled that they may well not adhere to in the austere atmosphere of the polling booth. Fourth, it is not clear how voter turnout might upset the polls.

I can appreciate both sides of the argument – it would be stupid and reckless of me to say otherwise when the polls are so close. I can understand that many Brits are disillusioned by and mistrustful of politicians and the members of the so-called economic elite with whom they often fraternise. They may not care about the risk of being financially worse off if they can feel personally empowered in other ways. On the other hand, there are many who believe that while the club that is the EU is not perfect – in any club there are always going to be rules that members find irritating – it is better to be in one than not in one. (It’s more complicated than this of course but I think this summary captures the essential sentiments on both sides, if not the formal arguments of those leading the campaigns).

As far as the psychology is concerned, the 2014 Scottish independence referendum provides a good guide. There was a very similar pattern in that, in the lead up to the vote, the polls and betting markets narrowed sharply and as a consequence financial markets got the jitters. When the time came, the vote to stay (“No”) won comfortably, 55.3% to 44.7%. Furthermore, the turnout was a very high 84.6%.

In the UK referendum. the remain campaign is not hindered by the “No” label, the negativity of which may well have made the Scottish vote closer than it would otherwise have been.

My view is that the aforementioned psychological considerations will favour the ‘remain’ campaign more than the ‘leave’ campaign and that, like the Scottish referendum, the outcome will not be as close as the polls are currently suggesting.
If I’m wrong, what then?

Even in the event of the ‘leave’ camp winning, I suspect sterling and equity markets will bounce in the immediate aftermath of the vote. This is the nature of markets. The situation is akin to Pascal’s wager, in which the great 17th century mathematician argued that there was no downside to believing that God exists – if you were wrong, it didn’t really matter. Similarly, there is one can argue no downside today to investors taking the view that the ‘leave’ campaign will win and selling their shares. Yes, you might not capture upside, but you won’t lose money. The utility of not losing it seems is far greater than that of winning, also known as loss aversion.

The logic of this argument is flawed, but then reason has rarely been the driver of markets in the short term – that role has been taken jointly by ‘fear’ and ‘greed’. The fact is, it is always more dangerous to sell than to not sell. If you sell and you are wrong, you incur a permanent loss, albeit an opportunity loss. If you don’t sell and you are wrong, you just have to wait for things to recover, as they almost always do. The loss is very likely temporary, and thus not permanent.

This is the view we have taken at Seneca. We are slightly overweight equities because we think they are generally cheap and the economic outlook, while not great, is OK (and in the case of our UK companies we think they can thrive either way). We are prepared to ride out short term volatility to the extent our already diversified multi-asset funds are exposed to it, and we would strongly encourage others to do the same.


Strategic asset allocation (SAA) review

We have just concluded our annual review of our funds’ strategic asset allocations. We have made some small changes to the underlying assumptions but not to the weights themselves.

To recap, our strategic asset allocation for a particular fund is constructed so as to achieve a particular real return – once fund costs and expected value added are accounted for – over the long term, as well as good diversification. Ultimately, we believe that by achieving a certain real return, the fund in question will attain top quartile status over the medium to long term in relation to its respective peer group. The inputs to the calculation for a particular fund are thus: (a) the long-term expected real returns we expect each of the asset classes in which our funds invest to achieve; (b) the real return objective of the fund; (c) the value added we expect to generate from active management and (d) fund costs. While we are aware of the volatilities of and correlations between asset classes, we do not use complex optimisation models. We do however model the SAAs to check that they have achieved in the past what we want them to achieve in the future.

Changes to the long-term return assumptions can be seen in the table below:

Table 1: Asset class long term real return expectations

Table 1 - Asset class long term real return expectations

The changes relate only to equities and within equities to all regions/countries other than North America (for which read ‘US’).

The rationale for the changes is simple: we think that economic growth is likely to be lower over the long term across the globe. At the same time, we acknowledge that US companies are probably more dynamic than in other parts of the developed world, and also that a negative adjustment should be made for the poorer governance of companies in emerging markets. In sum, this means a 1 percentage point reduction everywhere other than in North America.

We have not made any changes to expected returns within fixed income or specialist assets.

As for assumptions about the value added we can generate through active management, we have increased our targets for UK equities and overseas equities from 2% to 3% and from 1% to 1.5% respectively. This is an acknowledgement of our mid cap focus in the UK (mid cap stocks over time have beaten large caps by a significant margin, something we expect to continue). As for overseas equities, we are making more use of our capacity to be more concentrated as well as our capacity to invest in smaller, more dynamic funds. Both of these we feel increase our scope to add value.


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

Core inflation rates in the developed world have been fairly stable in recent months at around the 1.3% per annum level (see Chart 1). This is certainly an improvement compared with a year or so ago when the average was slightly below 1%, but is still short of where central banks would it to be. That said, core inflation in the US is around 2% which is where the Federal Reserve would like it to be (and hence why it has started to increase interest rates). In recent months, core inflation has started to trend downwards slightly in Europe and Japan – something the ECB and BOJ will be watching closely no doubt – but is still well above zero. Despite headline inflation numbers which are much lower as a result of food and energy price declines, central banks should be commended for maintaining price stability in recent years (with the exception of Japan whose success is more recent).

In the emerging world, the inflation picture continues to improve, with rates continuing to fall in Brazil and Russia, and stabilising around 2% in China (see Chart 2). India’s inflation remains a little higher than policymakers would like it to be, but it remains much lower than levels seen back in 2012 and 2013.

I have included this month a chart of year over year wage growth in developed economies (see Chart 3). As with core inflation rates, it is encouraging to see that wage growth in the US, the UK and Europe has remained in the 1.5-2.5% range, while in Japan it has risen from around -1% in 2013 to close to 1% currently. The assertion that Japan prime minister Abe is losing the battle against deflation is perhaps unwarranted.

Chart 1: Core consumer price inflation – developed economies

Chart 1 - Core consumer price inflation

Source: Bloomberg

Chart 2: Consumer price inflation – emerging economies

Chart 2 - Consumer price inflation - emerging economies

Source: Bloomberg

Chart 3: Wage growth – developed economies (YoY%)

Chart 3 - Wage growth - developed economies Source: Bloomberg


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

May’s non-farm payrolls of 38,000 came in well below expectations of 160,000. Furthermore, April’s payrolls were revised downwards from 160,000 to 123,000. The unemployment rate fell from 5.0% to 4.7% as the workforce shrank (having been rising since September last year, the participation rate has fallen back in April and May). Chart 5 below puts these numbers context. While the poor payrolls are of some concern, it is too early to say that they are the start of something more pronounced. There have been several months during the last six years when payrolls have come in well below 100,000 but did not signal the start of a downward trend. That said, we are now closer to the point at which employment is more likely to start to fall, so these numbers should be taken more seriously.

One conclusion that can be drawn from the data is that the probability of a June or July rate rise from the Fed is now much lower.

Elsewhere, unemployment rates in Japan, the UK, and Europe continued to fall. As can be seen in Chart 4 below, the average of the four countries/regions still has some way to fall before it hits the low point in the previous cycle.

Chart 4: Unemployment rate – developed economies

Chart 4 - Unemployment rate - developed economies

Source: Bloomberg

Chart 5: US employment indicators

Chart 5 - US employment indicators

Source: Bloomberg

Corporate sector indicators

Sales per share is often an interesting indicator to look at. Charts 6 and 7 below do just that, the first by geography and the second by industry. While the first suggests that the decline in the total (world) sales per share is fairly broad, the second suggests the decline is concentrated in four sectors: energy, materials, financials, and utilities (indeed this pattern can also be seen in Chart 8 which shows operating profit margins by industry). Nevertheless, it is clear that sales growth in the current cycle has been much weaker than in the previous two cycles. This is a reflection of the weak economic growth posted since the crisis. Why growth has been weak is a hard question to answer. Renowned economist Larry Summers has put forward a number of arguments as to why growth has stagnated in the US, many of which may also apply in other major developed economies.

I shall be looking at Summers’ research in more detail in next month’s letter.

Chart 6: Sales per share by geography (trailing, Dec 1995 = 100)

Chart 6 - Sales per share by geography (trailing, Dec 1995 = 100) Source: Bloomberg

Chart 7: Sales per share by industry (trailing, Dec 1995 = 100)

Chart 7 - Sales per share by industry (trailing, Dec 1995 = 100) Source: Bloomberg

Chart 8: Operating profit margin by industry (%)

Chart 8 - Operating profit margin by industry (%) Source: Bloomberg


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 2: Current fund tactical asset allocation (TAA) target weights(as of 31 May 2016, prior month’s targets in brackets)

Table 2 - Current fund tactical asset allocation - as of May 2016

      • No asset allocation changes in May for the OEICs
      • Minor asset allocation changes for the investment trust – fixed income increased to 7.0% from 6.6%, cash reduced to 1.0% from
        1.4%
      • SIGT: Introduced Britvic (target increased from 0% to 1.5%) and exited Aberforth Smaller Companies (target decreased from 1%
        to 0%)
      • Britvic’s yield of 3.3% offers good value in the context of stability of business and strength of brand
      • Aberforth exited on basis that the yield was not sufficiently attractive; also the holding did not align with our broad intention to invest directly only in UK
      • SDGF: introduced GCP Student Living (target increased from 0% to 1%), Aberdeen Private Equity Fund (0% to 0.7%), and exited
        NB Distressed Debt (1.7% to 0%)
      • GCP Student Living provides exposure to a niche and growing area of the property market and an attractive dividend yield of
        4.1%
      • Aberdeen Private Equity Fund continues to grow its NAV at a decent pace; it trades at a 33.3% discount to NAV
      • NB Distressed Debt exited on the basis that it does not provide the stability of returns that we seek from our specialist assets
      • SDIF: introduced Arrow Global Group (target increased from 0% to 1.0%), and reduced Fidelity Enhanced Income (2.0% to
        1.0%%)
      • Arrow Global is a market leader in acquisition of consumer debt; the company is growing earnings and dividend rapidly, yet its stock trades on a single digit P/E
      • Fidelity Enhanced Income reduced in line with move to replace indirect UK equity holdings with good value direct investments
      • SDIF: increased Royal London Sterling Extra Yield Fund (target increased from 4.0% to 4.6%), Royal London Global Short Duration High Yield Bond Fund (4.0% to 4.6%), and exited M&G Global High Yield Floating Rate Note Fund (1.2% to 0%)
      • The increases in the two Royal London funds were part of a further consolidation of fixed income positions, and also improved the income generation within SDIF
      • The M&G fund was exited as we felt the running yield of around 3% was unattractive given our view that a rise in UK interest rates that would benefit the fund is still some way off

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.05.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested.
This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/103.

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Peter Elston’s Investment Letter – Issue 13: May 2016

24 May 2016

Introduction of our new investment process – one year on.

Our new investment process reached the grand age of one in April. We thought it might be useful for clients and other readers to take a look back at how things have gone during the first year.

To recap, we are a multi-asset specialist and have three public multi-asset funds: our investment trust Seneca Global Income & Growth Trust and our two OEICs, CF Seneca Diversified Income Fund and CF Seneca Diversified Growth Fund. Each has its own strategic asset allocation which is linked to its specific long-term return objective. For example, in the case of the Growth Fund we expect over the long term to achieve a total real return net of costs of 6%. To achieve this, its strategic asset allocation comprises 60% equities (20% in UK and 40% non-UK), 15% fixed income and 25% specialist assets. For internal purposes, we use this strategic asset allocation as the fund’s performance benchmark, assigning an appropriate market index to each of the sub asset classes e.g. US equities, emerging market debt and so forth. Indeed, since December 2000, the Growth Fund’s strategic asset allocation has achieved a real trend return of 5.2% per annum. When expected value added from tactical asset allocation and holding selection in each of the four asset classes as well as fund costs are taken into account, this would get us to a real return of 6% per annum. It should also be noted that the last 15 years have included two particularly nasty bear markets in equities, so this trend return would have been depressed compared with previous decades. That said, this trend rate would also have been boosted somewhat by the strong performance of safe haven government bonds over the period.

So, the theoretical modelling is consistent with our actual fund objectives. What is not clear of course, and never will be, is whether markets over the medium to long term will perform as expected. Perhaps more importantly, whether we will be able to generate the value added that we expect to is also not guaranteed.

Back to the process.

Without doubt the two most important aspects of our new investment process relate to our investment style and the organisation of our research effort.

An investment style describes a framework for how investment decisions are made. Employ many different investment styles and you not only reduce your chance of making money – think “Jack of all trades master of none” – but you are also very likely to confuse your investor base. But having a clear investment style is not enough: buying only those companies with the colour orange in their logo is exceptionally clear but has no empirical or theoretical basis (you could quite easily be Tangoed).

Our new investment style which we formally introduced a year ago is called “Multi-Asset Value Investing”.

What does this mean?

It means that every investment decision we make is on the basis that something is fundamentally cheap (decisions to sell are made if something has become expensive). For example, a tactical asset allocation decision to overweight a particular equity market is made because we believe that the market in question is under-valued. In the UK, we invest directly, so a decision to buy a particular stock is made because it’s under-valued. Outside of UK equities we generally invest in third party funds, so we’re looking for managers who have some sort of value-oriented approach or who have identified cheap assets in a particular specialist area.

The theory is simple: cheap assets are more likely to appreciate in value than expensive ones. The empirical evidence is strong as well: various studies have found that high dividend stocks have outperformed low dividend stocks and that bull markets have generally begun when equity market yields are high.

Buying cheap assets won’t necessarily dampen volatility in the short term – an under-valued asset can often move even further away from its intrinsic value before moving towards it. What it will do however is help avoid permanent loss of real capital in the longer term. An example of this is developed market long-term government bonds. With their negative real yields, they are guaranteed to lose you money if held to maturity. However, by not holding them, fund volatility in the short term increases slightly, as not only are they low volatility but they also tend to be negatively correlated with so-called risky assets.

As for our other major change, we introduced in April last year specialist research responsibilities for each member of the investment team. Whereas previously it was the named fund managers who would decide what was in their funds, across all asset classes, under the new process it is a team effort. For example, Rich is a named fund manager on our Income Fund but is also now our specialist assets research specialist. This means he is responsible for analysing investments in his specialist area and deciding which ones we should own for all of our funds. Alan, Mark and Tom are responsible respectively for fixed income, UK equities and overseas equities whilst I cover asset allocation (strategic and tactical).

Research specialists make precise recommendations that require the approval of at least two of the other four members of the investment team, with approval granted if it is felt that sufficient research has been carried out and that the recommendation fits with our value-oriented investment style. This approval process we think is an important risk control, since it would be unwise to allow decisions to be made without any scrutiny of them or indeed to place all the responsibility for a decision on the shoulders of one person. But it is also important that the process is not too onerous and that specialists are allowed the scope to define how they do things in their asset classes within the broad parameters relating to our investment style. We believe we have the right balance.

As a direct result of these two key changes we have increased the commonality of holdings across funds. Previously our Growth Fund tended to buy growth stocks and our Income Fund only higher yielders. Tactical asset allocation could also be inconsistent. Under the new process the Growth Fund is a growth fund not because it owns different investments because it has a higher exposure to risky assets. So it now has many holdings in common with the income fund. This means that greater consistency in investment performance will be seen across all our funds. More often than not, if one of our funds is doing well in relation to its peer group, the others will be too.

As far as implementation is concerned, the Income Fund and our Investment Trust were fairly closely aligned with the new investment style to begin with – both funds had income-oriented mandates which lent themselves naturally to a more value-oriented approach. The Growth Fund however still requires further alignment and there remain five or six holdings to be exited. Indeed, over the last year the Income Fund and the Investment Trust have performed very well in relation to their respective peer groups, while the Growth Fund has languished somewhat. This is a direct consequence of the extent to which funds were already employing a value-oriented approach. Holders of the Growth Fund are assured that it will be fully aligned with the new investment process by the end of the third quarter of this year. We expect this to result in better long-term returns for investors in the fund.

Looking back at one or two of our investment decisions over the last year that help illustrate how the process is working in practice, perhaps the best examples are to be found at the beginning of this year. Mark, as UK equities specialist, wanted to recommend the purchase of three UK stocks that he believed had become cheap. He had the option to replace or reduce some of his existing UK equity holdings but I as tactical asset allocation specialist believed it was appropriate to increase the equity targets, given the extent to which markets had fallen. The question then for me was how we should fund this increase, whether by reducing our fixed income or our specialist assets positions (we generally run low cash balances unless we think markets are very overvalued). Our fixed income allocations were already on the low side, so after consultation with Rich, it was decided to reduce specialist assets (Rich agreed that many of his specialist assets had held up well and in fact two or three of them had seen their yields compress as a result of strong performance).

The three UK stocks that we added to funds in January and February were Royal Dutch Shell, International Personal Finance (IPF) and Victrex (we have a bias towards mid-caps which not only tend to outperform over time but also are less researched so present better opportunities to find hidden gems).

When Shell fell to below £13 in January, its historic yield reached around 10%, clearly discounting a big and permanent cut in future dividends. We felt that although a big cut was very possible (and still is), the high yield presented a big margin of safety – a 50% cut would still leave the shares yielding above 5%. Furthermore, although Shell’s upstream business was under pressure as a result of the low oil price, its downstream business was doing just fine, and in fact was to some extent benefitting from low oil prices. Finally, as far as the upstream business was concerned, Mark had noted that the forward oil curve was extremely steep, with prices two years out around 50% above prevailing spot prices. This suggested the spot price was particularly depressed for technical reasons such as speculative shorting or storage issues, and would thus likely rise. We bought the shares at an average of around £13.50. As of 12 May, they were trading at £17.54.

As for IPF, this is an emerging market home credit provider that had been spun out of Provident Financial in 2007. By 2013, the stock was a darling of growth fund managers, and the shares traded on a high valuation. In recent years however, countries in which it operated have introduced interest rate caps, which impacted the stock. Early this year the shares hit a yield of close to 6%, compared with well below 2% in its heyday. Now, interest rate caps may on balance hurt IPF’s business, but by no means terminally. Even at lower rates, the company is still able to find sufficiently high quality credits. Two other things. First, the mostly female agents get to know their mostly female customers by visiting them often and they are rewarded not on how much they lend but on how much they get back – a hark back to the early days of banking! Second, when governments realise that by introducing interest rate caps they are simply playing into the hands of loan sharks, they may well reconsider the legislation.

Outside of UK equities, a specialist asset that is illustrative of the new process is AEW UK REIT plc (indeed we purchased it at IPO in May 2015 and it was the first purchase made in any asset class under the new process). While we felt that prime property was becoming expensive, AEW was interesting because it was non-prime in the sense that it was focussing on smaller lot sizes, with shorter leases, and properties that needed more asset management (refurbishment). The management team was targeting 8-9% yields once fully invested, with dividends fully covered by income. Active asset management of the properties would be expected to bring total returns into the teens. We met the team in Liverpool and liked them. Since listing, the shares have returned 2.8% compared with a fall in the broad UK equity market of close to 10%. Furthermore, the annualised volatility of the shares has been 7.7%, nearly half that of the equity market.

To conclude, we have a unique and strong investment proposition. As an active manager, to produce good investment performance for investors, it is not only preferable to be different but essential – follow the crowd and you’re very likely to end up with poor performance net of costs.

We are different in a number of ways. We know that our “Multi-Asset Value Investing” investment style is unique – Google the term and you’ll only find Seneca. Buying things cheaply sounds like such an obvious thing to do but surprisingly few seem to follow the doctrine, at least in a formal, organised way. Investing directly in the UK and in mid-caps is also different and allows us not only to improve investment performance but to avoid the costs associated with third party funds. We have what we think is a high allocation of 25% of all our funds to specialist assets. These are mostly listed on the LSE, and in many cases offer high yields and stable, index-linked cash flows. Examples would be specialist REITs, asset leasing vehicles and renewable energy funds. They not only offer an alternative to equities but also to bonds. Finally, we have a well organised portfolio management and research system, with specialists responsible for maintaining target weights in their area of responsibility, for every mandate we manage. Named managers are given some discretion to deviate from targets but there are strict limits.

The new investment process has been well received and scored a number of successes in its first year. We thus hope and expect returns to continue to improve. So, on the occasion of its first birthday we extend to all our investors, the prospect of many happy returns.


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

It is interesting that despite rising concerns about the outlook for global economic growth in recent months, there has been no noticeable decline in core inflation (CPI less food and energy) across the developed world (see chart 1). Indeed, core inflation has actually been rising over the last 12 months in the US, the UK and Japan, though there has been a slight decline in Europe. The simple average for the four series is 1.4% as of March which although below what should be considered the target for developed country central banks, is not cause for serious concern. On the contrary, it means that monetary policy will remain loose which should be supportive of risky assets (bear markets tend to start when central banks are trying to bring inflation down).

As for emerging countries, there are signs of improvement (see chart.2). China’s inflation rate, which has been too low, has been rising, while Brazil’s and Russia’s, which have been too high, have been falling. India’s has been nudging up to around 5% over the last couple of years. This might be considered slightly on the high side, though is a vast improvement on the 10% rates seen in 2012 and 2013.

Chart 1: Core consumer price inflation – developed economies

PE IL 13 - May 2016 - Chart 1
Source: Bloomberg

Chart 2: Consumer price inflation – emerging economies

PE IL 13 - May 2016 - Chart 2
Source: Bloomberg

 


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Unemployment rates across the developed world have continued to improve (see chart 3). There seems to have been some fall in the rate of improvement in the US, the UK and Japan but this is only to be expected given that unemployment rates have been falling since 2009 (in Europe, unemployment only started to improve in 2013, and from much higher levels, so there the pace of improvement is if anything rising). The average of the four series stood at 5.9% as of March which should mean there is still plenty of scope for it to fall further. Indeed, during the last cycle from 2003 to 2008, the unemployment rate continued to fall for a further three years or so after it first hit 5.9%.

Furthermore, there are reasons to think that it can fall further and for longer than it did during the last cycle. In the case of the US, for example, although the unemployment rate has fallen a long way already, this masks the fact that the workforce has shrunk as a result of people having left the workforce. If as a result of the continued improvement many of them decide to re-enter it, this could well prolong the cycle (in fact this has started to happen, as evidenced by the rising participation rate). Second, there is evidence to suggest that the unemployment rate at which inflation starts to rise (also known as the NAIRU – the non-accelerating inflation rate of unemployment) has fallen. The Fed’s estimate of NAIRU fell from 5.6% in 2013 to 4.9% towards the end of last year. There is no reason to think it hasn’t fallen further since, meaning that employment may continue to rise without causing the Fed a headache.

As for emerging economies, data is sparse (see chart 4). Brazil is undergoing a nasty recession but the improvement in the inflation picture as noted in the previous section is encouraging.

Chart 3: Unemployment rate – developed economies

PE IL 13 - May 2016 - Chart 3
Source: Bloomberg

Chart 4: Unemployment rate – emerging economies

PE IL 13 - May 2016 - Chart 4
Source: Bloomberg


Other business cycle indicators

The OECD calculates leading indices every month for a large number of countries. Chart 5 below shows the year-on-year change in the leading indices for the UK, the US, Europe and Japan, as well as the four BRIC countries. It can be seen that the average growth rate over the last five or so years has been considerably lower than the 6% or so rate that prevailed prior to the 2008 financial crisis.

However, it is still positive at around 2% and appears to be stabilising. This stabilisation is evident in chart 6 below which shows the rate of change of the rate of change of the average (known as “the second derivative”). I would suggest that this is an improvement that has yet to be fully appreciated by equity markets.

Chart 5: OECD composite leading indicators (trend restored YoY%)

PE IL 13 - May 2016 - Chart 5
Source: Bloomberg

Chart 6: The rate of change of the average in Chart 5 (“the second derivative”)

PE IL 13 - May 2016 - Chart 6
Source: Bloomberg


Table 1: Current fund tactical asset allocation (TAA) target weights (as of 10 May 2016, prior month’s targets in brackets)

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.
PE IL 13 - May 2016 - Table 1
Source: Seneca Investment Managers, 10 May 2016

  • No asset allocation changes in April.
  • Introduced Primary Healthcare Properties (PHP) to all portfolios via its £150 million fundraising; having sold Assura earlier in the year on valuation grounds, PHP’s higher yield combined with its strong track record allowed us an opportunity to regain exposure to this interesting sector.
  • The purchases of PHP were funded by sales of Ediston Properties whose shares Rich felt had become too illiquid. He also felt that new stamp duty rules would make it harder for the management team to grow the REIT going forward.
  • Our investment trust sold its holding in BHP Billiton during the month, with proceeds moving into Arrow Global (a stock that was already held in the growth fund). Mark felt that the 70% rise in the share price since January presented an excellent opportunity to sell the holding, particularly given that both he and I felt the rally in commodity prices that had driven the appreciation was unsustainable.
  • The Growth Fund sold its holdings in its emerging markets healthcare ETF and its China fund (in favour respectively of the Somerset Emerging Markets Dividend Growth Fund and the First State Asia Pacific Leaders Fund). These sales were part of the aforementioned realignment of the Growth Fund, with neither fitting our investment style. The recipients of the proceeds are both funds that have good track records and value-oriented styles.

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 30.04.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested.
This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/84.

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Peter Elston’s Investment Letter – Issue 12: April 2016

18 April 2016

Introduction:

During a break at a conference I attended recently I was chatting to someone who said he thought that multi-asset investing was a gimmick. I tried hard to smile, saying simply that the idea of spreading one’s investments across different types of assets was as old as the hills, which it is.

But the reality is that multi-asset investing does have a bit of an image problem and as a multi-asset specialist we have to deal with that. Part of the problem, as with so much in our industry, relates to the use of jargon. When I began my career in 1988 with a large UK fund management house, most of the firm’s assets under management were “multi-asset” – in the form of defined benefit pension scheme assets. Many of these funds had around half their assets invested in UK equities, another fifth or so in overseas equities, another fifth in bonds and the rest in property and cash. To all intents and purposes they were multi-asset funds. We just didn’t call them “multi-asset”.

Then, over the course of the next couple of decades, the consultants took over, recommending to pension fund clients which manager they should select to manage which bucket of assets. They themselves would take on the job of asset allocation, while fund managers would be picked on the basis of their selection skills in equities, bonds or other asset classes.

To be fair to the consultants, the asset allocation function was ripe for an overhaul. At the firm where I started, it was the manager of the UK equity portion who was the central figure, with the job of asset allocation left to one individual who every quarter would look at the positioning of other pension funds as provided by CAPS or WM and tweak weightings accordingly. It was not sophisticated and the investment consultants, with their clever mean-variance optimization models, had a field day.

However, retail and wholesale demand for what would commonly become known as multi-asset funds was starting to rise. Alongside this, the absolute return fund came into being, as well as numerous other ways of making asset allocation decisions with the aim of generating good volatility-adjusted returns. As of 11 April, there were 573 OEICs across the six IA sectors that are either strictly multi-asset or, as is the case with targeted absolute return, have objectives that can be thought of as similar to those of multi-asset funds. The multi-asset landscape it seems is one that is competitive for us and confusing for our client base.

The way we try to address this is to get a good balance in our funds between simplicity and sophistication. The sophistication comes in the form of:

  • good diversification at an asset class level across equities, bonds and specialist assets that helps dampen volatility in the shorter term (though we certainly don’t purport to be absolute return managers);
  • a value oriented investment style that identifies assets which are undervalued and should thus perform well over the longer term;
  • a high conviction approach with respect to tactical asset allocation and security/fund selection that ensures funds are given the potential to produce value added in excess of fund costs.

The simplicity aspect is about steering clear of complex structured products, derivative strategies and hedge funds, as well maintaining a longer-term investment time horizon. Look at our funds’ holdings as well as our portfolio turnover and it should be pretty clear what we’re trying to do, something that we don’t think can be said of that many of our competitors.

Another major trend that was already underway in the late 1980s was the move towards passive investing. This trend was centred on equity funds where it was plain for all to see that the average actively managed fund in a particular geography underperformed its benchmark or the relevant benchmark index. More recently, funds that are designed to track more complex indices that are tilted towards a particular subsector or factor such as high dividend yield or high quality have grown in popularity. These funds are known as smart- or strategic-beta funds.

Although at a much earlier stage, there is a similar move towards passive and smart beta happening in the world of multi-asset. However, although similar, there are some key differences.

First, multi-asset funds use different types of benchmark, unlike equity funds that mostly use a stock market index (and in a particular geography, one benchmark index tends the prevail, an example being the S&P 500 index in the US). Some multi-asset funds use a composite index, the simplest being a 50/50  equity/bond index, some use the relevant peer group average, some use a nominal fixed return, some a real fixed return, and others still do not specify a benchmark at all.

Second, multi-asset funds, even within the same sector, can also vary enormously with respect to the volatility of their returns. Look at one of the IA multi-asset sectors and you will see a wide range of volatilities, unlike equity land where the ranges tend to be much narrower.

Third, and this is related to the first point, there are few ‘independent’ composite benchmarks in existence and fewer still funds that employ them. One example is the Dow Jones Global Composite Yield Index that is itself comprised of indices in five asset classes: equities, real estate, alternatives, corporate bonds, and sovereign bonds. However, although the first three of these are their own, Dow Jones uses Credit Suisse indices for the last two. Furthermore, I have been unable to find any funds that actually use it as their benchmark. All passive multi-asset funds that I have come across use their own composite benchmarks. Active funds that use a composite index as a benchmark also tend to create their own using different indices from different providers.

The world of multi asset does not easily lend itself to smart beta either. In the world of equities, it is now well understood that there are certain factors that tend to perform well over time such as smaller companies or stocks with high dividend yields. Furthermore, it is also well understood that creating indices to capture these factors is fairly straightforward.

Not so in multi-asset.

There have been attempts to create multi-asset indices whose weightings in underlying assets classes vary according to certain systematic rules. But these rules are necessarily bespoke and thus not becoming universally accepted and understood, as is the case in equity land. Their mystique may prevent them from enjoying the same success. The risks of something going wrong are surely too great.

Perhaps the biggest problem I see with passive multi-asset funds is that they may naturally have a significant and permanent weighting towards what are now extremely expensive government bonds. This may mean that they perform well over the short term, as has certainly been the case in recent months, but the negative long-term real yields that prevail in most if not all advanced countries mean one thing: over the longer term they are guaranteed to lose you money in real terms.

At Seneca, we believe that our active approach to multi-asset, one that avoids obviously expensive assets, is one that will over time produce stronger performance than a passive equivalent. Our volatility-adjusted investment performance numbers we think show just that.

 


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

As anticipated, inflation turning negative in the Eurozone in February did indeed prompt drastic action by the ECB, which announced a greater than expected increase in asset purchases. Elsewhere, it is encouraging to see Japan’s headline and core inflation numbers rising slightly in February, though no doubt the recent Yen strength will dampen prices down the line. As for emerging markets, both Brazil’s and Russia’s inflation rates have been falling noticeably which should be welcomed, though in both cases the numbers remain well above what would be considered comfortable levels.

Table 1: Inflation data releases over past month

IL 12 Table 1 Inflation data releases over the past month


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Unemployment in most regions remains above what might be considered full employment though we are getting close in the US and the UK. In the US, we are finally starting to see a rise in the participation rate, as those who previously left the workforce are being encouraged to return. This suggests employment can continue to rise for a while longer without impacting the unemployment rate and thus wage costs.

Table 2: Employment data releases over past month

IL12 Table 2 Employment data releases over past month


 

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 3: Current fund tactical asset allocation (TAA) target weights (as of 12 April 2016, prior month’s targets in brackets)
IL12 Table 3 Asset allocation
  • During March we increased the overall equity TAA target weight for all funds by 1 percentage point. This was something we had anticipated doing at some point, having in February raised cash by reducing the target in specialist assets.
  • The 1 percentage point equity target increase was spread across global funds, where we increased the target in Blackrock World Mining Fund, and Asia Pacific ex Japan.
  • Blackrock World Mining Fund remains very attractive, on a historical yield of 9.9%. It is very possible that the dividend will be cut this year, but even factoring this in, the yield is attractive.
  • As for Asia Pacific ex Japan, we think the region is becoming more attractive, having been underperforming for the last few years.
  • Elsewhere, we exited UK holding UBM plc for all funds. Following a very strong run since early February, the valuation is now less attractive. The current 17 times prospective PE is the highest since before the financial crisis.
  • The reduction in the UBM target was reassigned to different holdings depending on the fund. Indeed, our UK equity specialist took the opportunity to increase the commonality of holdings across portfolios.

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.03.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.
Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/67.

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Peter Elston’s Investment Letter – Issue 11 March 2016

14 March 2016

Executive summary:

I will be writing an opinion piece about emerging markets later this month for one of the trade journals. Here are some preliminary thoughts.

The big question with respect to emerging markets is when they’ll start performing. Since the second half of 2010, emerging markets have fallen by 45% in relation to developed markets. That by any standards is substantial and has prompted some to suggest that a change of fortunes is imminent. It is particularly interesting given that over the same period the MSCI AC World Growth index has outperformed its ‘Value’ counterpart by 15% (and by 29% since the end of 2006). If emerging markets embody anything it is ‘growth’, surely!

The term ‘emerging markets’ was coined in the early 1980s by then World Bank economist Antoine van Agtmael. He was trying to launch a fund investing in the new asset class and was persuaded that ‘The Third World Fund’ wasn’t sexy enough. Ever since, emerging markets have been considered a great place to invest.

Goodness knows why!

Since the end of 1987, emerging markets have returned 7.4% annually in US dollars. This compares with returns from US equities of 7.7% annually. Given that emerging market equities have been far more volatile than US equities and that economic growth has been much higher, you’d have expected equity returns to be much higher.

Why haven’t they been?

It is hard to generalise about a region that constitutes 23 countries and well over 800 companies but a key problem is that high economic growth has not filtered down to minority shareholders. Nowhere is this truer than China. Since 1992, China’s nominal GDP has increased 2,217%. Its stock market however has only risen 17% including dividends, equivalent to 4.1% in US dollar terms. On an annualised basis, 4.1% equates to 0.2% per annum. Where on earth did all that GDP go?!

Minority shareholders are just one of several stakeholders in any company. Others include employees, regional and central governments, and local suppliers. It seems that foreign investors who have poured money into emerging markets over the years have sorely underestimated the extent to which these other stakeholders would take their pound of flesh. In China’s case, raising wages has been a core tenet of government policy. This has been great for Chinese workers but will almost certainly have been at the expense of earnings per share.

Higher economic growth can be a double-edged sword. It has certainly been the main reason why foreigners have poured money into emerging markets but arguably is also the main reason why investment returns have been poor. Investment opportunities appear plentiful in emerging markets, where incomes are generally low and the scope to increase productivity is high. Companies with grand investment plans tended to be the ones that attracted greater foreign interest and thus cheaper equity finance. Returns on that investment have often fallen far short of expectations, unless of course you were one of the other stakeholders.

This point is one that was well made in a paper written in 2012 by Yale professor Martijn Cremers titled “Emerging Market Outperformance: Public-traded Affiliates of Multinational Corporations”. Cremers noted that the really strong performance in emerging markets has come not from the headline-grabbing, capital-absorbing local companies but from the listed affiliates of MNCs, which tend to have pretty dull businesses such as fast moving consumer goods. The combination of dull businesses and strong governance that permeated down from the parent made for a potent mix.


Chart 1: Value of US$1 invested in June 1998

Peter-Elston-Letter-March-2016-1

Source: Martijn Cremers – Emerging Market Outperformance: Public-traded Affiliates of Multinational Corporations

Cremers identified 92 such listed affiliates across emerging Asia, Eastern Europe, Africa and Latin America and found some startling results (see chart 1). Over the period under review, the 92 listed affiliates returned on average a total of 2,229% in US dollar terms. This compares with 1,157% for countries in which the affiliates were listed and 371% for emerging markets broadly (the affiliates tended to be listed in the better performing emerging markets).
The moral of the story is that one should be very selective in emerging markets. Companies with aggressive expansion plans have tended to disappoint while the dull and careful have delivered. In emerging markets, the tortoise wins the race.

Finally, a look at valuations. As can be seen in chart 2 below, there has been a stark divergence in price-to-book ratios of emerging and developed market companies. The gap may look appealing compared to where valuations were a few years ago but it has at times been much bigger. Back in the late 90s following the Asian financial crisis, the price-to-book ratio fell to 0.3 times at a time when the tech bubble was powering developed market companies to well over 3 times. While it is hard to imagine emerging markets getting that cheap again, it is worth remembering that if the return on capital is less than the cost of capital, as is often the case with emerging market companies, one should not pay more than 1 times book.


Chart 2: Price-to-book ratio of emerging markets versus developed markets

Peter-Elston-Letter-March-2016-2


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

Table 1: Inflation data releases over past month

Peter-Elston-Letter-March-2016-3

Source: Bloomberg  Mar 2016: Actual data was higher than/lower than/same as survey/prior/desired)

Perhaps the most important number coming out of the developed world was Europe’s February inflation turning negative. This prompted expectations of aggressive action by ECB president Mario Draghi at the central bank’s 10 March meeting. At the time of writing, the markets are coming off a little following what was a few hours ago a very positive reaction to the various stimulus measures announced by the ECB.

 


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Table 2: Employment data releases over past month

Peter-Elston-Letter-March-2016-4

Source: Bloomberg March 2016

Despite fears of slowing growth, unemployment rates almost everywhere came in lower than expected and, with the exception of Brazil, lower than or the same as the prior month. I’m still inclined to think that economies generally will continue to grow this year.


Current fund targets (as of 3 March 2016, prior month’s targets in brackets)

The targets in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 3: Current and previous target weights of our three public funds

Peter-Elston-Letter-March-2016-5

Source: Seneca Investment Managers, March 2016

  • Having increased the total equity weight by 2%pts in January, we increased it by a further 1%pt in February for all three funds via an increase in the UK equity target.
  • This brought the equity overweight to 5%pts in relation to strategic asset allocation.
  • We think that growth will remain sufficient this year to keep equities supported; however, if this is not the case and markets resume their downward trend, we have plenty of powder dry to increase the equity target further.
  • The 1%pt increase in the UK target was both top down and bottom up driven; we feel that the market is reasonably good value but the decision was also driven by our UK equity specialist putting forward a new stock idea.
  • The idea in question is International Personal Finance (IPF), a home credit provider operating in Poland, Lithuania, Romania, Bulgaria, Czech Republic & Slovakia, Hungary, Spain and Mexico.
  • The mostly female agents are remunerated based on loan repayments rather than the amount of loans extended, so are incentivised to get to know their mostly female clients well and to scrutinise credit risk.
  • The business has been impacted in recent years by interest rate caps introduced by governments of some of the companies in which they operate.
  • This has impacted sentiment towards the stock, which has fallen 60% from its highs in 2013 and is now yielding above 6%.
  • There is risk that governments in other countries in which they operate will also introduce interest rate caps but we think this risk is priced into the stock.
  • Furthermore, the unintended consequence of introducing interest rate caps is that borrowers are forced into the hands of loan sharks.
  • Thus there is also the possibility that interest rate caps are either removed or adjusted as politicians realise the errors of their ways (to the extent that politicians ever do!)
  • Elsewhere in portfolios, we reduced ‘specialist assets’ targets in anticipation of increasing further our equity targets; targets in specialist healthcare REIT Assura were reduced to zero as good performance had pushed the yield down to unattractive levels.

Download this investment letter as a PDF



Important Information

Past performance is not a guide to future returns. The information in this document is as at 29.02.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

CF Seneca Funds

These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc

Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/52.

 

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